Commercial Paper

How Does Commercial Paper Work?

Commercial paper (CP) is a money market instrument structured as an unsecured, short-term promissory note with a specified amount to be returned by an agreed-upon date.

Corporations often opt to issue commercial paper for purposes of meeting near-term liquidity needs, or more specifically, short-term working capital needs and expenses like payroll.

The notable benefit to these corporate issuers is that by choosing to raise capital via commercial paper, they do not have to register with the Securities and Exchange Commission (SEC) unless the maturity is longer than 270 days.

Commercial paper is an unsecured, short-term debt instrument issued by corporate borrowers to raise capital for periodic working capital needs.

Commercial paper (CP) is a type of short-term debt instrument with typical maturity of around a month, or 30 days.

The term “commercial paper” was originally used to describe the notes given to customers by merchants as receipts for cash payments made to them for goods and services received, which could later be used as cash by the customer.

In modern times, the term is used to describe a type of unsecured debt instrument issued by corporations to raise capital for their working capital needs.

Commercial paper is generally considered a short-term financing instrument, with a maturity around 30 days. The most common increments for the maturities for commercial paper are 30, 60, 90 and 120 days.

Given the short-term nature of the debt, interest rates on commercial paper are lower compared to long-term debt instruments like loans.

But unlike common equity, commercial paper does come with interest, which is determined based on market conditions at the time of issuance.

The interest rate on commercial paper is usually expressed as a percentage of the principal amount per period, and the frequency of interest is determined as well (e.g. interest is calculated and paid daily, monthly, etc.).

However, since CP is unsecured (i.e. not backed by collateral), investors must have faith in the issuer’s ability to repay the principal amount as outlined in the loan agreement.

The issuers of commercial paper are predominately large-sized corporations and financial institutions with high credit ratings.

Commercial paper thereby represents a convenient option for qualified companies to access the capital markets without having to go through the tedious SEC registration process.

Commercial Paper: What are the Features?

Commercial paper offers several attractive features for companies seeking short-term financing.

One of the primary advantages is convenient, quick access to cheap capital. Unlike bank loans, which can take weeks—or perhaps, months—to receive approval, commercial paper can be issued much faster, providing companies with rapidly accessible funds.

However, there is a trade-off to consider, where the maturity of commercial paper is restricted to no more than nine months, meaning that companies must repeatedly finance their short-term working capital needs.

Another key benefit of commercial paper is its generally lower interest rate compared to other forms of debt financing.

Why? The liquidity in the market for unsecured short-term debt is limited, which reduces the bargaining power of the seller.

However, it’s important to note that commercial paper is still tied to the market, so interest rates on the notes can fluctuate based on market conditions.

Commercial paper is typically unsecured, setting it apart from other forms of debt like mortgages or equipment loans. Therefore, in the event of default, the lender cannot seize any of the issuer’s assets.

This characteristic makes commercial paper particularly attractive for companies with strong credit ratings, as they can access financing without putting their assets at risk.

While commercial paper offers many benefits, it also comes with certain requirements and potential costs. Issuers often need to obtain a credit rating from a major credit rating agency, which can be expensive.

Additionally, commercial paper is sometimes issued with a guarantee from a bank or a letter of credit, which adds to the cost.

These factors, combined with the need for a strong credit rating, convey that commercial paper is primarily an option for large, financially stable corporations.

What are the Characteristics of Commercial Paper?

The standard structure of a financing arrangement with commercial paper is as follows:

• Types of Issuers ➝ Commercial paper is issued by large corporations with strong credit ratings as short-term debt to fund their short-term working capital needs.
• Term ➝ The typical CP term is ~270 days, and the debt is issued at a discount (i.e. zero-coupon bond) as an unsecured promissory note.
• Denomination ➝ Traditionally, commercial paper is issued in denominations of $100,000, with the primary buyers in the market consisting of institutional investors (e.g. money market funds, mutual funds), insurance companies, and financial institutions.
• Maturities ➝ The maturities on commercial paper can range from just a handful of days to 270 days, or 9 months. But on average, 30 days tend to be the norm for maturities of commercial paper.
• Issuance Price ➝ Similar to treasury bills (T-Bills), which are short-term financial instruments backed by the U.S. government, commercial paper is typically issued at a discount from face value.

Commercial Paper: What are the Risks?

The primary downside to commercial paper is that companies are restricted to using the proceeds on current assets, namely inventory and accounts payable (A/P).

Specifically, the cash received as part of the commercial paper arrangement cannot be used to fund capital expenditures (Capex) – i.e. the purchase of long-term fixed assets (PP&E).

Commercial paper is an unsecured form of debt, meaning that it is backed merely by investors’ trust in the issuer. In effect, only large corporations with high credit ratings can issue commercial paper at favorable rates and with enough liquidity (i.e. market demand).

Commercial paper is a short-term debt instrument issued by companies to meet immediate financing needs. Commercial paper must be repaid in full on the date of maturity, or else, the borrower is at risk of default.

Commercial Paper vs. Revolving Credit Facility: What Is the Difference?

Companies often face short-term working capital deficits and must choose between different financing options. Two common options are commercial paper and revolving credit facilities.

A revolving credit facility is a type of recurring financing that a company can draw down from when necessary, similar to a credit card, rather than receiving the funds all at once.

Unlike commercial paper, which must be repaid in full on the date of maturity, a portion of the revolving credit facility can be repaid whenever the company’s working capital balance exceeds its forecasted needs.

The interest is calculated based on the drawn balance, which helps to reduce the company’s interest expense if more of the debt principal is repaid. Interest rates on revolving credit facilities are usually lower compared to commercial paper, as revolving credit facilities are a secured form of financing.

The lender is authorized to seize the company’s assets if it defaults. Revolving credit facilities are typically extended to established, mature companies that the lender has an existing relationship with.

The process of obtaining a revolving credit facility is typically longer than that of commercial paper.

The terms are negotiated by the company’s banking team, including the interest rate, fees, and the maximum amount that can be drawn.

The maximum amount is often a function of the company’s historical financial performance, its current financial state, and management’s business plan for future growth. Once approved, the company can draw down as much of the funds as needed and only pay interest on the drawn amount.

The interest rate on a revolving credit facility is frequently determined based on the company’s senior unsecured credit rating, which is assigned by credit rating agencies.

Commercial paper can be issued by any corporate borrower that meets the eligibility criteria of the platform on which the paper is being issued. The process of obtaining commercial paper is often referred to as a “quick fix” for companies in need of short-term financing.

Both commercial paper and revolving credit facilities offer distinct advantages and disadvantages. Companies must carefully consider their specific needs, financial state, and relationship with lenders when choosing the most suitable financing option.

What is Asset Backed Commercial Paper (ABCP)?

One variation of commercial paper is asset backed commercial paper (ABCP), which is also a short-term issuance but is backed by collateral.

The issuers of ABCP are usually non-bank financial institutions (e.g. conduits) that provide collateral in the form of financial assets such as trade receivables and related payments expected to be received by the issuer in the future.

ABCP tends to be less restrictive and could be used for longer-term spending needs (i.e. capex), rather than only short-term liquidity and working capital needs.

Before the Great Recession, ABCP formerly represented a substantial proportion of the money market industry, when it was primarily issued by commercial banks. The creditworthiness of ABCP issuances collapsed, however, due to risky collateralization with mortgage-backed securities (MBS), which contributed to the 2008 Global Financial Crisis.

The liquidity crisis that ensued exposed the vulnerabilities in the U.S. money market system, resulting in more strict regulations to be placed, and less capital allocated to the ABCP sector.