What is a Backup Line?

Malcolm Tatum

Also known as a backup line of credit, a backup line is one form of a line of credit that can be used to cover the issue of any type of commercial paper. This additional line of credit helps to cover the issue when it is not possible to issue new paper in order to finance the process. A credit line of this type is normally presented in the form of a letter of credit or may be included as a part of a larger contractual agreement.

Man climbing a rope
Man climbing a rope

There are a number of ways to make use of a backup line as part of the financing for a commercial paper. One approach is to have the amount of the backup provide complete or whole coverage for the paper. At other times, the additional line of credit may only cover a percentage of the paper, but usually at least half of that worth. The amount of coverage provided by the backup line is often determined by the worth of the commercial paper in question. For a lower grade paper, the coverage is normally greater, while a higher grade paper will receive less cover from the backup credit line.

Payments on a backup line of credit are typically managed in one of two ways. One approach is to pay for the paper with compensating balances from other assets associated with the commercial paper. A second method is to assess a simple straight fee, based on the amount of the credit line that is actually called into use. Both approaches have their advantages and liabilities, making it necessary to evaluate each situation individually before determining which arrangement is the best option.

As with any line of credit, a backup line is there for use when and as needed. It is conceivable that the line of credit may never be used at all, depending on how the primary financing for the commercial paper functions. In a sense, this means that the backup line is somewhat like an insurance plan that provides support in the event that something occurs with the maturing notes that calls for some sort of additional financing. While establishing a backup credit line may take some time and effort, the fact is that having one in place does provide some peace of mind to both the issuers of the commercial paper and investors who choose to buy into the opportunity. From this perspective, the credit line helps to make the option more attractive to buyers and increases the chances for successfully selling the notes.

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