What Is Commercial Paper?

Commercial paper serves as a short-term, unsecured debt instrument predominantly utilized by businesses to cover immediate financial obligations like payroll, accounts payable, and inventory expenses. The duration of these debts varies, typically between one and 270 days, with a common average term being approximately 30 days. This type of paper is sold at a discount and is valued at its nominal amount upon maturity. Its issuance starts at a minimum value of $100,000, offering a fixed interest rate that adjusts in response to market fluctuations.

Basics

Corporations issue commercial paper as a means of short-term, unsecured borrowing, mainly to address immediate financial needs like payroll, accounts payable, and inventory costs. This type of debt is often sold at a discount compared to its face value, aligning with current market interest rates. The structure of commercial paper includes a predetermined repayment sum, set to be paid back by a specific due date. Typically, the minimum investment in commercial paper is set at $100,000, with the maturity period ranging from one day to as long as 270 days, though the average term is around 30 days.

Exploring the Origins of Commercial Paper

Over a century and a half ago, New York merchants began selling their short-term obligations to intermediaries, seeking capital to fulfill imminent responsibilities. These intermediaries, also known as dealers, acquired the obligations, referred to as promissory notes, at a discounted rate from their face value. Subsequently, they retailed these notes to banks and other investors. The merchants would then reimburse the investors an amount equivalent to the face value of the note.

Commercial paper, constituting unsecured debt without collateral backing, marked its inception during this period. It distinguishes itself from asset-backed commercial paper (ABCP), a debt instrument secured by assets chosen by the issuer. Notably, both types of commercial paper are exclusively issued by entities boasting high credit ratings, enabling them to attract buyers without resorting to substantial discounts, thus minimizing costs associated with debt issuance.

Issued in denominations of $100,000 or more, commercial paper primarily caters to large institutions. Corporations, financial entities, and affluent individuals are frequent patrons of this financial instrument.

The inaugural figure to venture into the money market for commercial paper transactions was Marcus Goldman, the visionary founder of Goldman Sachs, the prominent investment bank. Post the Civil War, his company burgeoned into one of America's premier commercial paper dealers.

Understanding the Two Main Forms of Commercial Paper: Promissory Notes and Drafts

Commercial paper is categorized into promissory notes and drafts. Promissory notes, often just referred to as notes, are written obligations where one party pledges to pay a certain sum to another by a specified deadline. These notes are frequently utilized by companies for issuing commercial paper. On the other hand, a draft involves three entities: a bank, known as the drawer, a payer called the drawee, and the payee. In this arrangement, the bank directs the issuer of the commercial paper to remit a predetermined amount to the lender, the payee, at an agreed-upon time.

Key Aspects of Commercial Paper

Issuer

Commercial paper, a short-term debt instrument, is issued by entities, primarily large corporations with strong credit ratings, to address immediate cash flow needs. These issuers are generally deemed capable of repaying their debts, particularly in the short term. 

Maturity

The duration, or maturity, of commercial paper, typically extends up to 270 days, with many companies opting for 30 days. Upon maturity, the debt becomes due, obligating the issuer to repay investor capital, although they might choose to issue new commercial paper instead.

Secured/Unsecured

Unlike secured debts, commercial paper usually lacks collateral, meaning if the issuer becomes bankrupt, the paper holders may have limited options for recovery. The short maturity period and the issuer's creditworthiness often negate the need for asset backing.

Face Value

In terms of value, commercial paper is issued at face value, usually in $100,000 denominations. Rather than accruing interest, it is often sold at a discount, allowing investors to receive the full face value at maturity despite having paid less initially.

Liquidity

The liquidity aspect of commercial paper is crucial, reflecting a company's ability to manage short-term debts with its cash flow. Issuers produce commercial paper to boost short-term liquidity, while buyers, not needing immediate cash, invest to enhance their future cash reserves. Although similar to bonds, commercial paper possesses distinct features.

Advantages of Commercial Paper

One of the significant advantages of commercial paper is its exemption from registration with the Securities and Exchange Commission (SEC), provided its maturity period does not exceed 270 days (or nine months). This aspect significantly reduces the complexity and cost of financing for issuers. While the maturity of commercial paper can extend up to 270 days before requiring SEC oversight, it typically averages around 30 days.

Furthermore, issuing commercial paper is often more straightforward and less time-consuming than securing a business loan, making it an attractive financing option. It not only provides issuers with comparatively lower interest rates but also assures investors of a minimal risk of default. Additionally, commercial paper is a useful tool for investors looking to diversify their investment portfolios.

Disadvantages of Commercial Paper

To issue commercial paper, a company needs to have an exceptional credit rating, which limits its availability to all businesses. The funds raised through commercial paper are specifically allocated for current assets or inventories, and usage for fixed assets like a new plant requires the involvement of the Securities and Exchange Commission (SEC).

The benefit for issuers in terms of lower interest rates translates to modest returns for investors. Additionally, the high minimum investment requirement of $100,000 generally excludes smaller investors from directly participating in the commercial paper market, though they can still invest indirectly via entities that purchase commercial paper.

Differences Between Commercial Paper and Bonds

Commercial paper and bonds, while both serving as debt instruments, exhibit distinct differences essential for investors to understand. The maturity period of commercial paper is significantly shorter, ranging between one and 270 days, in contrast to bonds, which have a maturity span of one to 30 years. Typically, bonds are considered longer-term debt, although a portion might be classified as short-term in company reports.

In terms of payment structure, commercial paper is unique in that it involves a single repayment at maturity, without any interim coupon payments. Bonds, conversely, offer regular interest payments, commonly semi-annually, throughout their duration, in addition to the return of principal at maturity.

Another key difference lies in collateral. Long-term bonds often come with a security feature, giving investors priority claims on company assets in case of any issues. This makes many bonds secured, providing an added layer of safety for investors, in contrast to commercial paper, which is typically unsecured and mirrors riskier bonds in this aspect.

Illustration of a Commercial Paper Transaction

Imagine a retail company needing to acquire new inventory for an upcoming holiday season, requiring $10 million in short-term financing. To raise this amount, the company issues commercial paper valued at $10.1 million, aligning with the current interest rates. Upon the maturity of the commercial paper, investors will receive a return comprising both the original $10 million loan and an additional $100,000. This additional sum represents an effective interest rate of 1%, which can be adjusted depending on the duration the paper is held. Consider the scenario where the commercial paper's term is set at 30 days. In this case, the retail firm secures the required $10 million immediately and is then obligated to repay $10.1 million to the commercial paper holders after 30 days.

Conclusion

Commercial paper, a form of unsecured short-term debt typically not exceeding 270 days, is favored by corporations with strong credit histories as a cost-effective alternative to conventional business loans for covering immediate expenses. This financial instrument often appeals to issuers because of its relatively low-interest rates. Although these rates may not always entice investors, they can offer better returns compared to certain bonds, like Treasuries. Commercial paper also serves as a tool for diversifying investment portfolios.

The primary market for commercial paper consists of institutional investors, largely due to the substantial minimum investment requirements. While commercial paper is generally considered a low-risk investment option owing to the high creditworthiness required of issuers, it's important to recognize that it still carries some inherent investment risk, as is the case with all financial instruments.