What is Commercial Paper?
Commercial paper is a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities. Maturities on commercial paper typically last several days, and rarely range longer than 270 days. Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.
Understanding Commercial Paper
Commercial paper was first introduced over 150 years ago when New York merchants began to sell their short-term obligations to dealers that acted as middlemen in order to free up capital to cover near term obligations. These dealers would thus purchase the notes at a discount from their par value and then pass them on to banks or other investors. The borrower would subsequently repay the investor an amount equal to the par value of the note.
Commercial paper is not usually backed by any form of collateral, making it a form of unsecured debt. As a result, only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue. Because commercial paper is issued by large institutions, the denominations of the commercial paper offerings are substantial, usually $100,000 or more. Other corporations, financial institutions, wealthy individuals, and money market funds are usually buyers of commercial paper.
Marcus Goldman of Goldman Sachs was the first dealer in the money market to purchase commercial paper, and his company became one of the biggest commercial paper dealers in America following the Civil War.
Advantages of Commercial Paper
A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months, or 270 days, making it a very cost-effective means of financing. Although maturities can go as long as 270 days before coming under the purview of the SEC, maturities for commercial paper average about 30 days, rarely reaching that threshold. The proceeds from this type of financing can only be used on current assets, or inventories, and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.
Commercial Paper During the Financial Crisis
The commercial paper market played a big role in the financial crisis that began in 2007. As investors began to doubt the financial health and liquidity of firms such as Lehman Brothers, the commercial paper market froze, and firms were no longer able to access easy and affordable funding. Another effect of the commercial paper market freezing was some money market funds - substantial investors in commercial paper - "breaking the buck." This meant that the affected funds had net asset values under $1, reflecting the diminishing value of their outstanding commercial paper issued by firms of suspect financial health.
The Commercial Paper Funding Facility (CPFF) was subsequently created by the Federal Reserve Bank of New York on October 27, 2008, as a result of the credit crunch faced by financial intermediaries in the commercial paper market. The Federal Reserve Bank of New York closed the CPFF in February 2010 after it no longer became necessary as the financial sector and broader economy recovered.
Example of Commercial Paper
An example of commercial paper is when a retail firm is looking for short-term funding to finance some new inventory for an upcoming holiday season. The firm needs $10 million and it offers investors $10.1 million in face value of commercial paper in exchange for $10 million in cash, according to prevailing interest rates. In effect, there would be a $0.1 million interest payment upon maturity of the commercial paper in exchange for the $10 million in cash, equating to an interest rate of 1%. This interest rate can be adjusted for time, contingent on the number of days the commercial paper is outstanding.
(For more on this topic, see: Introduction To Commercial Paper.)