What is a Backup Line of Credit?

A backup line gives protection to the investors of a company if the company defaults on the commercial paper it offers. Commercial paper is an unsecured short-term debt security that a company offers to its investors rather than issuing them bonds or stocks. Commercial papers have a maturity period of less than a year, their redemption value is often their face value amount. Usually, a company with a high credit rating engages in this type of arrangement. In a case where the company defaults on its commercial paper, a backup line can offer protection to the investors.

How Does a Backup Line of Credit Work?

A backup line is a Line of Credit (LOC) in which a company that offers commercial papers to its investors is required to pay a fee to a bank. The fee paid to a bank is an exchange for a backup line that protects its investors in case of default by the company. The bank uses the backup line to settle the company’s commercial papers. A company that pays a fee in exchange for a backup line can either cover all of its commercial paper by the backup line or a part of it. Companies with high credit ratings use backup lines as an effective plan to pay off commercial paper in a case of default.

How a Backup Line Works

A company can decide to use a backup line for a number of reasons. A company with high credit ratings can use this plan, companies that want to undergo significant expansion in their business line can also opt for a backup line. For example, a fabric company that wants to purchase a heavy equipment for manufacturing fabrics can issue commercial paper worth $2 million to its investors instead of bonds or stocks. Due to the tendency of the company defaulting on the commercial paper, the company goes to a bank and require for a backup line equivalent to the commercial paper issued. The backup line would be used to pay off its commercial paper if it defaults. Banks offer backup lines to companies in exchange for a fee.