Commercial Paper: Definition, Advantages, and Example

Commercial Paper

Investopedia / Madelyn Goodnight

What Is Commercial Paper?

Commercial paper is an unsecured, short-term debt instrument issued by corporations. It's typically used to the finance short-term liabilities such as payroll, accounts payable, and inventories.

Commercial paper involves a specific amount of money that is to be repaid by a specific date. Minimum denominations are $100,000. Terms to maturity extend from one to 270 days. They average 30 days.

Commercial paper is usually issued at a discount from face value. It reflects prevailing market interest rates.

Key Takeaways

  • Commercial paper is a form of unsecured, short-term debt.
  • It's commonly issued by companies to finance their payrolls, payables, inventories, and other short-term liabilities.
  • Maturities on commercial paper range from one to 270 days, with an average of around 30 days.
  • Commercial paper is issued at a discount and matures at its face value.
  • The minimum denomination of commercial paper is $100,000 and it pays a fixed rate of interest that fluctuates with the market.
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Commercial Paper

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 in order to access capital needed to cover near-term obligations.

These dealers, or middlemen, purchased the paper, (also known as promissory notes) at a discount from their par value. They then sold the paper to banks and other investors. The merchants would repay the investors an amount equal to the par value of the note.

Commercial paper is not backed by any form of collateral, making it unsecured debt. It differs from asset-backed commercial paper (ABCP), a class of debt instrument backed by assets selected by the issuer.

In either case, commercial paper is only issued by firms with high ratings from credit rating agencies. These firms can easily find buyers without having to offer a substantial discount (at a higher cost to themselves) for the debt issue.

Commercial paper is issued by large institutions in denominations of $100,000 or more. Other corporations, financial institutions, and wealthy individuals, are usually buyers of commercial paper.

Marcus Goldman, the founder of investment bank Goldman Sachs, was the first dealer in the money market to purchase commercial paper. His company became one of the biggest commercial paper dealers in America following the Civil War. 

Types of Commercial Paper

There are four types of commercial paper: promissory notes, drafts, checks, and certificates of deposit (CDs).

Promissory Notes

Promissory notes, or, simply, notes, are debt instruments written by one party to another that promise to pay a specific amount of money by a certain date. Notes are a common way for companies to issue commercial paper.

Drafts

A draft is a written agreement between three parties: a bank (the drawer), a payer (the drawee), and a payee. The bank instructs the commercial paper issuer to pay the lender (payee) a specific amount of money at a specific time. 

Checks

Checks are paid on demand by a bank rather than by a certain time. They are the fastest way to issue commercial paper. For this type of commercial paper, the issuing company instructs a bank to give the payee a specific amount of money instantly.

Certificates of Deposit

A certificate of deposit is exactly what the name implies: a bank receipt, or certificate, that asserts that the bank has received a sum of money deposited by an investor. It agrees to pay back this money plus interest at a specific time in the future. The CD also states the interest rate to be paid and the maturity date. 

Advantages and Disadvantages of Commercial Paper

Advantages

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 in no more than nine months, or 270 days.

This makes it a cost-effective and a simple 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.

Commercial paper is also easier to deal with compared to the effort, time, and money involved in getting a business loan.

It offers issuers the advantage of lower interest rates while it offers investors a low risk of default.

Commercial paper provides an effective way for investors to diversify portfolios.

Disadvantages

Companies must have extremely good credit to issue commercial paper. So, it doesn't offer access to capital for all institutions.

What's more, the proceeds from this type of financing can only be used on current assets or inventories. They are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.

Low interest rates for issuers mean low rates of return for investors. Also, due to the large minimum denomination of $100,000, commercial paper typically isn't directly available to smaller investors. However, they can invest indirectly through companies that buy commercial paper.

Pros and Cons of Commercial Paper
Pros  Cons
Issuers can access capital markets without having to register securities with the SEC Commercial paper isn't FDIC-insured
Issuers can get funding without having to get a business loan There's no guarantee that investors will be repaid
Issuers risk of default is low Companies must have high credit ratings, so not all can use this funding option
Great for diversification purposes Low rates of return for investors

Commercial Paper vs. Bonds

Both commercial paper and bonds are debt instruments. However, there are important differences between them that are useful to know.

Commercial paper maturities extend from one to 270 days. Bonds mature in one to 30 years.

Commercial paper has no coupon payments. Everything is repaid at maturity, with one payment. Bonds pay interest at regular intervals (twice a year) over the life of the loan.

Example of Commercial Paper

Let's say a retail firm is looking for short-term funding to finance some new inventory for an upcoming holiday season.

The firm needs $10 million. It offers investors commercial paper with a face value of $10.1 million. This is in line with prevailing interest rates.

When the commercial paper matures, investors in effect receive an interest payment of $100,000 along with the $10 million they loaned out. This equates 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.

Is Commercial Paper a Type of Debt?

Yes. Commercial paper is short-term, unsecured debt issued by institutions who want to raise capital needed for a short amount of time. It's an alternative to having to go through the effort and cost involved in getting a business loan.

Who Are the Primary Buyers of Commercial Paper?

Due to the large minimum denominations (usually $100,000 or more), large institutions comprise the main buyers of commercial paper. According to the SEC, these include "investment companies, retirement accounts, state and local governments, financial and non-financial firms."

How Do Individuals Invest in Commercial Paper?

The minimum investment in commercial paper is usually $100,000. So the best way for smaller investors to invest in commercial paper is to put their money in the companies that buy it. These include money market funds, mutual funds, and even exchange-traded funds.

The Bottom Line

Commercial paper is unsecured debt with short terms (up to 270 days) issued by companies with high credit ratings. It offers a less expensive way to raise money to pay short-term expenses compared to getting a business loan.

Commercial paper can also be attractive for issuers due to the low interest rate that's usually attached to it. While that rate isn't always as appealing to investors, it can be a higher return than that offered by some bonds (such as Treasuries). Plus, it's an investment option that can help diversify portfolios.

Investors in commercial paper are usually institutions rather than individuals, due to the large minimum denominations involved.

Commercial paper may be seen as a low risk investment due to the high credit rating preferred for issuers. Bear in mind, however, that like any other investment, it involves some degree of risk.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Board of Governors of the Federal Reserve System. "Commercial Paper Rates and Outstanding Summary."

  2. U.S. Securities and Exchange Commission. "Primer: Money Market Funds and the Commercial Paper Market."

  3. Federal Reserve Bank of Richmond. "Commercial Paper," Pages 13-14.

  4. Goldman Sachs. "Entrepreneurialism and Grit Inspire Marcus Goldman to Launch his Business."

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