What it means
Large companies fund day-to-day needs by issuing commercial paper, which is unsecured short-term debt sold to money market investors and repaid within a few months. The risk is refinancing risk, because each piece of paper has to be repaid by selling new paper, and if investor appetite disappears the company faces a sudden cash demand.
A backup line closes that gap by giving the company a contractual right to borrow from its banks instead. The facility is committed, which is the important word.
A committed line means the bank is legally obliged to lend when the company asks, subject only to the conditions written into the agreement, unlike an uncommitted overdraft the bank can withdraw at will. That obligation is what makes the line count as genuine liquidity.
Credit rating agencies expect to see this cover before they assign a short-term rating to a commercial paper programme, and many lenders expect backing close to the full amount of paper outstanding. Without it, investors would be lending into a programme with no visible escape route.
The line therefore does two jobs: it protects the company, and it supports the rating that makes the cheap short-term funding possible in the first place. The cost is a commitment fee on the undrawn amount, plus interest at an agreed margin on anything actually drawn.
Because the fee is far smaller than the interest on a drawn loan, a backup line is a cheap way to buy certainty, and the saving on commercial paper against bank borrowing usually more than covers it. The pricing is set in the facility documents and typically steps up with the borrower's leverage or rating.
The detail that matters most is the conditions attached. A line with a material adverse change clause or tight financial covenants may be unavailable at exactly the moment the company is in trouble, so treasurers negotiate hard for clean drawdown conditions and spread the commitment across several banks so that no single lender's problems can shut the facility.
In practice
Real-world examples.
Example
A listed retailer funds seasonal stock purchases with commercial paper and holds a backup line equal to 100% of the paper it has outstanding. The commitment fee costs it $750,000 a year, which its treasurer describes to the board as the premium on an insurance policy.
Example
A utility is told by a rating agency that its short-term rating depends on committed backup cover for the full programme. It replaces a single bilateral facility with a syndicated line split across eight banks, so that one lender's withdrawal cannot leave it short.
Example
A manufacturer discovers during a refinancing that its backup line contains a material adverse change clause. Because the clause would let the banks refuse to lend in exactly the circumstances the line exists for, the treasurer pays a higher fee for a facility without it.
Formula
Calculation
Annual cost of a backup line = (commitment fee rate multiplied by the undrawn amount) plus (the all-in borrowing rate multiplied by the drawn amount). A company arranges a facility of $200,000,000 as backup for its commercial paper. The agreement sets an illustrative commitment fee of 0.25% a year on the undrawn balance and an illustrative all-in borrowing cost of 6.0% a year on anything drawn. While nothing is drawn, the cost is 0.25% multiplied by $200,000,000, which is $500,000 a year. If the paper market closes and the company draws $40,000,000, the undrawn balance is $160,000,000, so the commitment fee becomes 0.25% multiplied by $160,000,000, which is $400,000, and interest on the drawn amount is 6.0% multiplied by $40,000,000, which is $2,400,000. Total cost in that year is $400,000 plus $2,400,000, which is $2,800,000.Case study
Seen in the real world.
Calloway Chemicals is an illustrative, fictional speciality chemicals group used here to show why backup lines exist. It funded $300,000,000 of working capital with rolling commercial paper, saving about $3,000,000 a year against the cost of drawn bank debt, and held a committed backup line of $300,000,000 at a commitment fee of 0.20%, costing $600,000 a year.
When a fictional industry-wide credit scare closed the short-term paper market for six weeks, Calloway could not roll $120,000,000 of maturing paper. It drew that amount under the backup line, repaid the investors on time, and returned to the paper market once conditions settled.
The illustrative point is that the $600,000 fee bought an outcome worth far more than its cost: no missed repayment, no emergency asset sale and no downgrade, which is the whole purpose of paying for liquidity you hope never to use.
Watch out
Common mistakes.
- Counting an uncommitted overdraft as backup liquidity, when the bank can withdraw it at the first sign of difficulty.
- Assuming an undrawn facility is free, when the commitment fee is a real annual cost that belongs in the finance line of the forecast.
- Ignoring the drawdown conditions, so the line turns out to be unavailable in exactly the stress it was bought for.
Questions
People also ask.
Why not just borrow from the bank in the first place?
Because commercial paper is normally cheaper than drawn bank debt, so paying a small fee for standby cover and borrowing short-term from investors costs less overall.
How large should a backup line be?
Lenders and rating agencies typically expect cover close to the full amount of short-term paper outstanding, and many issuers hold cover for the entire programme.
Does drawing on a backup line look bad?
It can signal stress to investors, which is why treasurers prefer to draw quietly and in part, and why facilities are sized to allow a partial draw rather than an all-or-nothing call.
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