Commercial Paper: The Efficient Path to Short-Term Corporate Financing
Commercial paper is an unsecured, short-term debt instrument issued by corporations, primarily to cover short-term liabilities such as payroll, accounts payable, and inventories. Typically issued at a discount from its face value, commercial paper reflects the prevailing market interest rates.
Commercial paper involves a specific sum of money that must be repaid by a set date, with a minimum denomination of $100,000. Its term to maturity ranges from one to 270 days, averaging around 30 days.
Key Takeaways
- Commercial paper is a form of unsecured, short-term debt.
- It’s commonly issued to finance payrolls, payables, inventories, and other short-term liabilities.
- Maturities range from one to 270 days, with an average of around 30 days.
- Issued at a discount and matures at its face value.
- Minimum denomination is $100,000, with a fixed interest rate aligned to market conditions.
The History and Evolution of Commercial Paper
Commercial paper traces its roots back to colonial times, initially known as a bill of exchange. Its modern form began to take shape in the 1920s, when New York merchants started selling short-term obligations to dealers as a means of securing capital for near-term debts. These dealers bought the commercial paper at a discount and sold it to banks and other investors, who were repaid the face value of the note upon maturity.
Characteristics of Commercial Paper
Issuer
The issuer is usually a large corporation with robust creditworthiness, capable of offering commercial paper without collateral.
Term/Maturity
Maturity refers to the period that the debt is outstanding. Commercial paper can have a maturity of up to 270 days, but averages around 30 days.
Secured/Unsecured
Generally unsecured, commercial paper does not involve collateral. Instead, the high creditworthiness of issuers typically secures it.
Discount/Face Value
Issued at a discount, commercial paper is bought at a price lower than its face value. Upon maturity, investors receive the face value, effectively earning an interest.
Liquidity
Commercial paper boosts a company’s liquidity profile, providing immediate cash flow solutions for short-term expenses. From an investor’s standpoint, it offers future cash-value gain opportunities.
Types of Commercial Paper
Promissory Notes
These plain vanilla debt instruments represent a promise to pay a specific amount by a certain date. They are commonly used by companies to issue commercial paper.
Drafts
Involving three parties— a bank (drawer), a payer (drawee), and a payee — drafts represent an agreement for a specified sum of money to be paid at a specified time frame.
Advantages and Disadvantages of Commercial Paper
Advantages
- Cost-effective and simple means of financing without needing SEC registration for maturities up to 270 days.
- Easier to handle compared to traditional business loans.
- Offers competitive interest rates with lower default risks and portfolio diversification benefits.
Disadvantages
- Only available to companies with excellent credit ratings.
- Proceeds can’t be used for fixed assets without SEC involvement.
- Generally not accessible to smaller investors due to the high denomination requirements. Investors often need to engage through funds that buy commercial paper.
Commercial Paper vs. Bonds
Commercial paper and bonds are both debt instruments, but they cater to different financing needs. While commercial paper offers short-term financing up to 270 days without periodic interest payments, bonds often entail longer maturity up to 30 years with regular interest payments. Additionally, many bonds tend to be asset-secured, whereas commercial paper is typically unsecured.
Example of Commercial Paper in Action
Imagine a retail firm needing $10 million to finance new inventory for an upcoming holiday season. The firm offers commercial paper with a face value of $10.1 million. Assuming the term is 30 days, the firm will receive $10 million upfront from investors. At maturity, they repay $10.1 million, effectively offering a 1% interest rate for the period.
Investing in Commercial Paper
Commercial paper offers attractive alternatives to traditional business loans for corporations. For individual investors, investing through entities like money market funds, mutual funds, or ETFs provides indirect access to this secured-corporate debt instrument.
The Bottom Line
Issued by creditworthy corporations as an alternative to traditional loans, commercial paper offers a viable, cost-effective means to address short-term liquidity needs. Though not without risk, its high credit rating requirement makes it a largely safe investment choice with competitive returns. Primarily accessible to institutions due to high denomination requirements, commercial paper remains a cornerstone of modern corporate financing and institutional investing.
Related Terms: Treasury Bills, Bonds, Corporate Bonds, Money Market Funds.
References
- Federal Reserve Bank of Richmond. “Commercial Paper”. Pages 13-14.
- U.S. Securities and Exchange Commission. “Primer: Money Market Funds and the Commercial Paper Market”.
- Federal Reserve Bank of New York. “FAQs: Commercial Paper Funding Facility”.
- Goldman Sachs. “Entrepreneurialism and Grit Inspire Marcus Goldman to Launch his Business”.
- Moorad Choudhry. “Corporate Bonds and Structured Financial Products; Chapter Commercial Paper”, Page 414. Elsevier Science, 2004.
- Mayer Brown. “Commercial Paper Programs Presentation”. Page 26.
- Board of Governors of the Federal Reserve System. “Commercial Paper Rates and Outstanding Summary”.
- Financial Industry Regulatory Authority. “Bonds: Overview”.
