Caterpillar Inc.'s (CAT) financing arm could soon face higher borrowing costs that would undermine profits already eroded by rising loan defaults, debt analysts say.

The U.S. construction equipment maker's April 21 forecast of sharply lower income and sales for 2009 has prompted credit rating agency reviews that observers say nudged Caterpillar Financial Services closer to becoming ineligible to issue low-yield commercial paper.

"If you get taken out of the commercial paper market your cost of funds goes higher and your profitability will continue to be under pressure," said Joel Levington, director of corporate credit for Hyperion Brookfield Corporate Credit in New York.

Maintaining Caterpillar Financial's liquidity is a critical part of the company's response to the global slump in construction spending and equipment demand. Caterpillar, like other equipment makers, has used its finance company to counter sharply lower sales and tightening credit conditions for its customers and dealers.

Caterpillar Financial has been able to efficiently raise capital by selling short-term commercial paper. Without commercial paper, though, the company would likely resort to issuing longer-term notes with higher rates.

Wide spreads between Caterpillar Financial's borrowing costs and the interest charged on its loans made financial products a reliable profit generator, supplying an average of 15% of the company's annual operating income for the past five years.

"There's no question that it's been a big supporter of the earning power of the company for the last few years," said Lawrence De Maria, an analyst with Sterne, Agee & Leach Inc. "That's coming to an end."

Illinois-based Caterpillar expects operating income from its financial products, which include loans and leases, to fall about 40% this year from 2008 as a result of tighter spreads, rising delinquencies and reduced sales. For the first quarter, revenue from financial products fell 12% from a year ago, while operating income dropped 49%. Loans in the company's portfolio that were past due by 30 days grew to 5.4% in the first quarter from 3.8% at the end of last year. Bad-debt write-offs more than doubled from a year ago, to $47 million.

Caterpillar said it continued to use the commercial paper market during the first quarter and anticipates having sufficient capital for the rest of the year.

The company, which reported a first-quarter loss on big restructuring charges, halved its 2009 earnings forecast from earlier this year to $1.25 per share. It reduced its sales estimate by about 30% from $51 billion last year.

Standard & Poor's Ratings Service responded by changing its outlook on Caterpillar and Caterpillar Financial to "negative" from "stable," but affirmed its ratings. Fitch Ratings, meanwhile, lowered Caterpillar's long-term corporate rating a notch to "A" from "A+," but did not change the company's short-term commercial paper rating.

Moody's Investors Services in January lowered its outlook on the company to "negative."

Observers say the agencies' moves set the stage for more significant downgrades later in the year unless the company's business begins to rebound.

To bolster the agencies' confidence in Caterpillar and hedge against less access to credit in the months ahead, the company stockpiled more than $3 billion of cash on its balance sheet in recent months.

Chief Executive James Owens said last week the cash hoarding is likely to continue as long as the company's liquidity and credit ratings remain uncertain.

"There's a lot of pressure on companies to build liquidity." he said during comments to reporters.

Caterpillar's stock closed Tuesday up 2.42% at $39.41 a share

-By Bob Tita, Dow Jones Newswires; 312-750-4129; robert.tita@dowjones.com