Commercial Paper: Definition, Advantages, and Example

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 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.

Understanding Commercial Paper

Commercial paper was first introduced during colonial times and was referred to as a bill of exchange. They became more modern during the 1920s when New York merchants began to sell their short-term obligations to dealers 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 an unsecured debt and will usually have a higher yield. 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.

Types of Commercial Paper

There are a bunch of different types of commercial paper, as companies can issue different forms of items depending on the criteria they’re willing to commit to. Here are the main types of commercial paper:

Promissory Notes

Promissory notes are written promises to pay a specific amount of money on a certain date. They are used by companies to borrow funds without having to use any collateral, and promissory notes can range from just a few days to up to a year. Promissory notes are sold at a discount from their face value and redeemed at face value upon maturity, meaning the difference between those two amounts is technically the interest earned.

Drafts

Drafts are orders written by one party (the drawer) directing another party (the drawee) to pay a specified sum to a third party (the payee). The drawee is usually a bank. As commercial paper, drafts can be used in trade financing to facilitate the purchase of goods and services. Drafts can be either sight drafts which are payable on demand or time drafts which can be payable at a specific future date.

Bankers' Acceptances

Bankers' acceptances are time drafts that have been accepted and guaranteed by a bank. They are commonly used in international trade to ensure payment to exporters. The bank's acceptance of the draft means that the bank promises to pay the face value of the draft at maturity (which gives certain parties a level of security). Bankers’ acceptances can also be traded in the secondary market before maturity.

Certificate of Deposits (CDs)

CDs are time deposits issued by banks that pay a fixed interest rate for a specified period. CDs are considered low-risk investments since they are backed by the issuing bank; however, there may be a dollar cap as to the amount that is insured. While they are technically not unsecured like most commercial paper, large denominations of CDs are often included in the broader category of commercial paper because of their relative level of liquidity and short-term nature (assuming a more brief CD length). 

Repurchase Agreements (Repos)

Repos are agreements in which one party sells securities to another with a promise to repurchase them at a specified price on a future date. Although repos are secured by the underlying securities, they are frequently used as a form of short-term borrowing in the money markets. Because a repo transaction includes the initial sale and the repurchase agreement, it acts as a short-term loan.

Commercial Paper Terms

Issuer

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.

Term/Maturity

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).

Secured/Unsecured

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.

Discount/Face Value

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.

Liquidity

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.

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 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.

Who Issues Commercial Paper?

Commercial paper is usually issued by large corporations with strong credit ratings. The important part here is that commercial paper usually does not require collateral; therefore, in order to issue commercial paper, these companies usually have to be in good standing with strong external relationships. 

These types of companies can range across differing industries. For example, manufacturing companies may issue commercial paper. As manufacturers require an influx of inventory as part of their business cycle, they may not have enough capital on hand to buy goods they need (which they, ironically, need in order to sell in order to raise capital). Issuing commercial paper gives these types of companies upfront capital they may need to kickstart revenue cycles. Note that commercial paper is useful here only if the company expects to convert the raw materials into revenue in a relatively short amount of time.

Another type of issuer of commercial paper could be service providers. In a similar example as above, consider a consulting firm that provides legal services. In order to generate income, these firms have to pay staff. However, without upfront capital to pay staff, the firms can’t generate that income. By issuing commercial paper, these firms get the money upfront they need to drive revenue. Again, just like with manufacturing companies, the service provider should expect to be able to generate short-term income to align with the commercial paper cycle.

Who Buys Commercial Paper?

Commercial paper is primarily invested in by institutional investors due to its nature and characteristics. These investors include money market funds that aim to maintain liquidity while earning a modest return. Money market funds prefer commercial paper due to its short maturity and relatively low risk, fitting well within their investment strategies that emphasize safety and liquidity.

Corporate treasurers also invest in commercial paper as part of their short-term cash management strategies. Companies with excess cash often seek to park their funds in high-quality, short-term instruments that can be quickly liquidated if needed. Instead of having corporate cash sit by the wayside not generating income, corporations can buy commercial paper to generate revenue while not having to take on any substantial level of risk or sacrifice longer-term corporate strategy. Pension funds, insurance companies, and other institutional investors with a mandate to manage large sums of money may also invest in commercial paper.

Lastly, banks and other financial institutions are usually also prominent investors in commercial paper. They use it as part of their asset-liability management strategies to match the durations of their assets and liabilities more effectively. For instance, if a bank has a number of short-term liabilities coming due, it can choose to maximize the efficiency of its capital by investing in commercial paper with the same maturity of that debt.

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 its 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.

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.