What Is Commercial Paper?
Commercial paper is an unsecured, short-term debt instrument issued by corporations. It's typically used to finance short-term liabilities such as payroll, accounts payable, and inventories. Commercial paper is usually issued at a discount from face value. It reflects prevailing market interest rates.
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 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.
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, 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.
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 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.
Commercial Paper Terms
The issuer of commercial paper is the entity that is creating the short-term debt to fund their short-term cash needs. As mentioned earlier, most issuers are large corporations with strong credit, as the issuer may demonstrate a high probability of being able to pay back debt especially in the short-term.
The maturity of commercial paper designates how long the debt is outstanding for the issuer. Commercial paper often a term up to 270 days, though companies often issue commercial paper with a maturity of 30 days. At the end of the maturity period, the commercial paper is technically due, and the issuer is now liable to return investor capital (though they may choose to simply re-issue more commercial paper).
Commercial paper is often unsecured, which means there is no collateral for the debt the issuing company is taking on. If the issuing company goes bankrupt, holders of the issuer's commercial paper may not have recourse in receiving funds. The idea is because commercial paper's maturity is so short and the credit worthiness of issuers is higher, the debt does not need backing by corporate assets.
Commercial paper is issued at face value, meaning a debt instrument has a value to it often in denominations of $100,000. Instead of paying interest, commercial paper is instead often issued at a discount, or a price that less than face value. When the commercial paper reaches maturity, the investor will receive the face value amount of the instrument even though they paid a lower discount amount.
Commercial paper is often tied to liquidity, the measurement of well a company's short-term cash flows will be able to cover its short-term debt. Therefore, issuers often create commercial paper to increase their liquidity as it may need cash in the short-term. On the other hand, buyers of commercial paper may not need cash right away, so they are willing to buy and hold the instrument to increase their cash on hand in the future.
Commercial paper is just like bonds, though each instrument has its own unique characteristics.
Advantages and Disadvantages 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 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.
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|
|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. Though a company may report part of their bonds as short-term debt, a majority of bonds are usually longer-term compared to commercial paper.
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. Though both instruments result in a return of capital at the maturity date of the instrument, bonds also make payments along the way.
Another potential difference between the two is the collateral requirements. For long-term bonds, investors will often want security that if something were to happen, they have the first right to claim company assets. Therefore, many bonds may be secured, while the riskiest bonds may more closely mirror commercial paper by being unsecured.
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.
Say the term of the commercial paper is 30 days. This means the firm will raise $10 million today and in 30 days, it may repay $10.1 million to investors holding the commercial paper.
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.
Board of Governors of the Federal Reserve System. "Commercial Paper Rates and Outstanding Summary."
U.S. Securities and Exchange Commission. "Primer: Money Market Funds and the Commercial Paper Market."
Federal Reserve Bank of Richmond. "Commercial Paper," Pages 13-14.