LOC Paper

LOC paper definition

Letter of credit (LOC) paper is defined as a short-term security guaranteed by a bank letter of credit and is one of the primary forms of commercial paper along with asset-supported commercial paper securities. While large scale corporations with outstanding credit ratings often issue commercial paper without guarantors, smaller and credit-challenged companies often must obtain backing for their commercial paper securities. Some companies put up assets as collateral, while others pay a fee to large banks and lending institutions to obtain a letter of credit.

LOC paper and the commercial paper market

It is believed that commercial paper first came into existence in New York in the 1860s, but may have been in circulation even before that time. These short-term promissory notes were used by businesses to raise funds quickly; today, commercial paper serves much the same purpose for large corporations and smaller companies that require ongoing cash infusions in order to pursue their financial goals. LOC paper is typically issued by companies that lack the credit history, commercial credit rating, or collateral to issue commercial paper without a guarantee or by guaranteeing it with company-held assets. Instead, these companies pay a fee to a financial institution and, in turn, receive a letter of credit equivalent to the entirety or a portion of the value of the LOC paper to be issued.

Why LOC paper?

For many companies, issuing LOC paper allows them to meet ongoing expenses or take advantage of business opportunities that might otherwise pass them by. Generally, the yield paid out on LOC paper is significantly less than the cost of borrowing the same amount of money, even when the origination fee is factored into the equation. For many smaller or credit-challenged companies, LOC paper represents an easy and cost-effective way to break into the commercial paper marketplace and offers significant cash-flow benefits for such companies as well.

LOC paper in practice

Like other forms of commercial paper, LOC paper is typically issued for three to six month periods as part of an ongoing series of issues. Companies sometimes issue new LOC paper securities in order to pay off maturing ones; this is a risky maneuver, however, since it may prove difficult to sell the new issue depending on the current economic and market environment. In these cases, the company may elect to obtain an additional line of credit to support the added risk these rollovers represent.

Investing in LOC paper

Typically, LOC paper securities can be purchased directly from the issuer or through an intermediary dealer; in both cases, investors are advised to look closely at the financial condition of the company and the risk vs. reward scenario before investing. While most LOC paper investments are relatively secure, the moderate rate of return is reflected in the moderate risk assumed; as a result, investors may be better served by investing in securities that offer lower risk or a higher rate of return on the initial investment.
Tim Ord
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