Commercial Paper
Definition
Commercial Paper (CP) refers to an unsecured, short-term debt instrument issued by corporations to finance their immediate operational needs, such as inventory or payroll. Typically, it has a maturity of less than 270 days, making it a short-term financing solution. Commercial paper is issued at a discount to face value, and the issuer repays the full face value at maturity. Because it is short-term and unsecured, commercial paper is considered a lower-risk investment compared to longer-term, more volatile debt securities.
Characteristics of Commercial Paper
Unsecured: Unlike other debt instruments such as bonds, commercial paper is unsecured, meaning it is not backed by any collateral. This makes it riskier than secured debt, though it is still considered a relatively safe investment for institutional investors.
Short-Term Maturity: Commercial paper typically has a maturity of up to 270 days. It can be issued with maturities as short as a few days or as long as 9 months, but it cannot exceed 270 days under U.S. Securities and Exchange Commission (SEC) regulations.
Discounted Issuance: CP is issued at a discount to its face value. The issuer receives less than the face value upfront, and investors receive the face value at maturity. The difference between the issue price and the face value represents the return to the investor.
Large Denominations: Commercial paper is typically issued in large denominations, with a minimum face value of $100,000. This makes it primarily accessible to institutional investors, such as mutual funds, insurance companies, and pension funds, rather than individual investors.
Low Risk: Due to the short maturity period and the creditworthiness of the issuing corporations, commercial paper is considered to be relatively low risk, but the risk still exists, particularly for companies with lower credit ratings.
Example of Commercial Paper Issuance
A company like Apple Inc. may issue commercial paper to meet short-term cash needs. For example, if Apple needs $10 million for operational costs, it may issue a 90-day commercial paper at a discount. Suppose the commercial paper is issued at 99% of its face value, so investors purchase the CP for $9.9 million. After 90 days, Apple repays the $10 million face value to the investor, with the $100,000 difference representing the return.
How Commercial Paper Works
Issuance: A corporation issues commercial paper through a dealer, who acts as an intermediary between the issuer and investors. The corporation sets the terms of the paper, including the amount to be raised, the discount rate, and the maturity date.
Investors: Investors in commercial paper typically include large institutional investors like money market funds, insurance companies, and pension funds, as well as corporations that seek short-term investments. These investors purchase CP with the expectation of a low-risk, low-return investment.
Maturity: Upon reaching maturity, the issuer repays the face value of the commercial paper. If the issuer has enough cash flow or capital, it may repay the debt in full. If not, the issuer may roll over the CP by issuing new commercial paper to pay off the existing debt.
Advantages of Commercial Paper
Low Cost of Borrowing: Commercial paper is a cost-effective way for companies to obtain short-term financing. Because it is unsecured and typically issued by creditworthy corporations, the interest rates on CP are usually lower than other forms of short-term borrowing, such as bank loans.
Flexible Financing Option: Companies can issue CP as needed to meet short-term liquidity needs. The flexibility to adjust the size and timing of commercial paper offerings makes it an attractive financing tool for many corporations.
Short-Term Commitment: With maturities generally under a year, commercial paper allows companies to avoid long-term debt obligations while meeting immediate financing needs.
Efficient for Investors: For institutional investors, commercial paper provides an opportunity to invest in short-term, relatively low-risk instruments. It offers a higher return than typical savings accounts or Treasury bills, and investors can sell their holdings before maturity if necessary.
Risks of Commercial Paper
Credit Risk: Since commercial paper is unsecured, it carries the risk that the issuing company might default on its repayment. The risk is typically low for highly-rated companies, but the risk increases for lower-rated or smaller companies. In the event of default, investors may not receive their full investment back.
Liquidity Risk: While commercial paper is typically liquid, it is less liquid than other government-backed short-term instruments like Treasury bills. Investors may have difficulty selling their holdings before maturity, particularly during periods of market stress or for paper issued by lower-rated companies.
Market Risk: Commercial paper yields are sensitive to changes in interest rates. When interest rates rise, the prices of existing commercial paper may fall, potentially causing investors to incur losses if they sell before maturity.
Roll-Over Risk: Many issuers of commercial paper rely on the ability to roll over their maturing debt by issuing new commercial paper. If market conditions worsen or if the issuer’s credit rating is downgraded, it may become difficult or more expensive for the issuer to roll over the debt.
Regulation of Commercial Paper
In the United States, commercial paper is regulated by the Securities and Exchange Commission (SEC), which requires issuers to file certain disclosures for CP with maturities longer than 270 days. However, because of its short maturity, CP is exempt from the usual SEC registration requirements, making it quicker and less expensive to issue compared to other forms of debt.
Who Uses Commercial Paper?
Large Corporations: Companies with strong credit ratings use CP as a financing tool to raise funds for their day-to-day operational needs without committing to long-term debt.
Money Market Funds: These funds are the primary investors in commercial paper, seeking to earn a return on short-term, low-risk instruments.
Banks and Financial Institutions: Some banks may issue CP to manage their short-term liquidity and funding needs.
Commercial Paper vs. Other Short-Term Debt Instruments
Treasury Bills (T-Bills): T-bills are government securities that are issued with maturities of up to one year. Unlike commercial paper, T-bills are backed by the U.S. government and are considered one of the safest investments. They typically have lower yields compared to commercial paper.
Certificates of Deposit (CDs): CDs are time deposits offered by banks, usually paying higher interest than savings accounts. Unlike commercial paper, CDs are insured by the FDIC up to a certain amount and typically require a fixed investment period.
Repurchase Agreements (Repos): Repos involve the sale of securities with an agreement to buy them back later at a higher price. Repos can be a quick and low-risk method for short-term borrowing, but they are typically used by institutional investors rather than corporations for operational financing.
Conclusion
Commercial paper is an important tool for short-term corporate financing. It provides companies with a quick and flexible means to meet their immediate financial needs. While it carries some risks, particularly with regard to credit and liquidity, it remains a popular choice for high-quality corporations and institutional investors. Understanding how commercial paper works, its benefits, and its risks is essential for anyone involved in short-term financing or investment.