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, 澳洲幸运5官方开奖结果体彩网:accounts payable (AP), 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 and average 30 days.

Understanding Commercial Paper

Commercial paper was introduced during colonial times and was referred to as a bill of exchange. In the 1920s, New York merchants began selling their short-term obligations to dealers for capital to cover near-term obligations. These dealers, or 澳洲幸运5官方开奖结果体彩网:middlemen, purchased the paper (also known as promissory notes) at a discount from their par value. They sold it 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 澳洲幸运5官方开奖结果体彩网:usually have a higher yield. It differs from 🦄澳洲幸运5官方开奖结果体彩网:asset-backed com🔯mercial 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 澳洲幸运5官方开奖结果体彩网: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 different types of commercial paper, as companies can issue various forms of items depending on their criteria. Let's take a look at the main types.

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 ju🌟st 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. This means the difference be🍸tween these two a🥂mounts is technically the interest earned.

Drafts

Drafts are orꦚders 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 time𒆙 drafts which can be payable at a specific future date.

Bankers' Acceptances

Bankers' acceptances are time drafts that are accepted and guaranteed by a bank. They are commonly used in 澳洲幸运5官方开奖结果体彩网:international trade to ensure payment to exporters.

The bank's acceptance means it promises to pay the face value of the draft at maturity, giving certain parties a level of security. Bankers’ acceptances can also be traded in the 澳洲幸运5官方开奖结果体彩网:secondary market before maturity.

Certificate of Deposits (CDs)

澳洲幸运5官方开奖结果体彩网:Certificates of deposit (CDs) are time deposits issued by banks that pay a fixed interest rate for a specified period. CDs are considered low-risk inve𒅌stments 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 commeꦓrcial 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)

澳洲幸运5官方开奖结果体彩网:Repurchase agreements (repos) 🐻involve one party who sells securities to another with a promise to repurchase them 𒁏at a specified price on a future date.

Repos are secured by the 澳洲幸运5官方开奖结果体彩网:underlying securities and are frequently used as a form of short-term borrowing in the 澳洲幸运5官方开奖结果体彩网: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 creating the short-term debt to fund their short-term cash needs. 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 designates how long the debt is outstanding for the issuer. Commercial paper often has a term of up to 270 days, though companies often issue commercial paper with a maturity of 30 days. The commercial paper is technically due upon maturity and the issuer must return investor capital or simply re-issue more commercial paper.
• Secured/Unsecured: Commercial paper is often unsecured, which means there is no 澳洲幸运5官方开奖结果体彩网:collateral for the debt. If the issuing company goes bankrupt, the investors may not have a way to get their money back. That's because commercial paper's maturity is so short and the 澳洲幸运5官方开奖结果体彩网:creditworthiness of issuers is higher, the debt does not need backing by corporate assets.
• Discount/Face Value: Commercial paper is issued at 澳洲幸运5官方开奖结果体彩网:face value, meaning a debt instrument has a value to it often in denominations of $100,000. Instead of paying interest, commercial paper is issued at a discount or a lower price than its face value. The investor receives the face value amount of the instrument at maturity even though they paid a lower discount amount.
• Liquidity: Commercial paper is often tied to 澳洲幸运5官方开奖结果体彩网:liquidity. Therefore, issuers often create commercial paper to increase their liquidity to meet any short-term needs. 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 Comm💃ercial Paper

Advantages

• Doesn't need to be registered: Commercial paper doesn't 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. 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.
• Cheap alternative: It is a cost-effective and simple means of financing.
• Easy to deal with: Commercial paper is easier to deal with compared to the effort, time, and money involved in getting a business loan.
• Lower rates and low risk: It offers issuers the advantage of lower interest rates while it offers investors a low 澳洲幸运5官方开奖结果体彩网:risk of default.
• Diversification: Commercial paper provides an effective way for investors to 澳洲幸运5官方开奖结果体彩网:diversify portfolios.

Disadvantages

• Issuers must have good credit: Companies must have extremely good credit to issue commercial paper.
• Only good for current assets or inventories: The proceeds can only be used on current assets or inventories. They are not allowed to be used on 澳洲幸运5官方开奖结果体彩网:fixed assets, such as a new plant, without SEC involvement.
• Offers low returns: Low interest rates for issuers mean low rates of return for investors.
• Not suitable for all investors; 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 澳洲幸运5官方开奖结果体彩网:credit ratings, which meansꦚ it does not require collateral. To issue commercial papꦦer, these companies usually have to be in good standing with strong external relationships. These companies can range across differing industries.

For example, manufacturing companies may not have enough capital on hand to buy the goods they need to produce their goods. Issuing commercial paper gives them the upfront capital needed to kickstart their revenue cycles. Note that commercial paper is useful here only if the company expects to convert the 澳洲幸运5官方开奖结果体彩网:raw materials into reven🧸ue in a relatively short amount 🥂of time.

澳洲幸运5官方开奖结果体彩网:Service providers may also issue commerc🔯ial paper. Consider a consulting firm that provides legal services. Without the upfront capital to pay their sta🐠ff, these firms can’t generate income. By issuing commercial paper, these firms get the money they need to drive revenue. As with manufacturing companies, service providers should expect to generate short-term income to align with the commercial paper cycle.

Who Buys Commercial Paper?

Institutional investors are the main buyers of commercial paper. These investors include 澳洲幸运5官方开奖结果体彩网: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 relativ🦂ely low risk, fitting well within their investment strategies that emphasize safety and liquidity.

Corporate treasurers also invest in commercial paper for short-term cash management. Companies often invest excess capital in high-quality, short-term instruments that can be quickly liquidated if needed. Corporations can buy commercial paper to generate revenue without taking on any substantial level of risk or sacrificing their corporate strategy. 澳洲幸运5官方开奖结果体彩网:Pension funds, insurance companies, and other in🦹stitutional investors with a mandate to manage large sums of money may also invest in commercial🅰 paper.

Banks and other💫 financial institutions are usually 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 short-term liabilities coming due, it may 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 impor♉tant 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 ins꧃truments result in a retur𒈔n 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 wants short-term funding to finance some new 澳洲幸运5官方开奖结果体彩网:inventory for an upcoming holiday season. The firm needs $10 millio꧃n. 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 m💖illion 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 investor💯s holding the commercial paper.

The Bottom Line

Commercial paper is unsecured debt with short terms issued by companies with high credit ratings. It is a less expensive way to raise money for short-term expenses compared to a business loan. Commercial paper can 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.