An Introduction to Commercial Paper

The world of fixed-income securities can be divided into two main categories. Capital markets consist of securities with maturities of more than 270 days, while the money market comprises all fixed-income instruments that mature in 270 days or fewer. The commercial paper falls into the latter category and is a common fixture in many money market mutual funds. This short-term instrument can be a viable alternative for retail fixed-income investors who are looking for a better rate of return on their money.

Commercial Paper Characteristics

Commercial paper is an unsecured form of promissory note that pays a fixed rate of interest. It is typically issued by large banks or corporations to cover short-term receivables and meet short-term financial obligations, such as funding for a new project. As with any other type of bond or debt instrument, the issuing entity offers the paper assuming that it will be in a position to pay both interest and principal by maturity. It is seldom used as a funding vehicle for longer-term obligations because other alternatives are better suited for that purpose.

The commercial paper provides a convenient financing method because it allows issuers to avoid the hurdles and expense of applying for and securing continuous business loans, and the Securities and Exchange Commission (SEC) does not require securities that trade in the money market to be registered. It is usually offered at a discount with maturities that can range from one to 270 days, although most issues mature in one to six months.

History of Commercial Paper

Commercial paper was first introduced over 100 years ago when New York merchants began to sell their short-term obligations to dealers that acted as intermediaries. These dealers would purchase the notes at a discount from their par value and then pass them on to banks or other investors. The borrower would then repay the investor an amount equal to the par value of the note.

Marcus Goldman of Goldman Sachs was the first dealer in the money market to purchase commercial paper, and his company became one of the biggest commercial paper dealers in America following the Civil War. The Federal Reserve also began trading commercial paper along with Treasury bills from that time until World War II to raise or lower the level of monetary reserves circulating among banks.

After the war, commercial paper began to be issued by a growing number of companies, and eventually, it became the premier debt instrument in the money market. Much of this growth was facilitated by the rise of the consumer credit industry, as many credit card issuers would provide cardholder facilities and services to merchants using money generated from commercial paper. The card issuers would then purchase the receivables placed on the cards by customers from these merchants (and make a substantial profit on the spread).

A debate raged in the 1980s about whether banks were violating the Banking Act of 1933 by underwriting commercial paper since it is not classified as a bond by the SEC. Today commercial paper stands as the chief source of short-term financing for investment-grade issuers along with commercial loans and is still used extensively in the credit card industry.

Commercial Paper Markets

Commercial paper has traditionally been issued and traded among institutions in denominations of $100,000, with notes exceeding this amount available in $1,000 increments. Financial conglomerates such as investment firms, banks, and mutual funds have historically been the chief buyers in this market, and a limited secondary market for this paper exists within the banking industry.

Wealthy individual investors have also historically been able to access commercial paper offerings through a private placement. The market took a severe hit when Lehman Brothers declared bankruptcy in 2008, and new rules and restrictions on the type and amount of commercial paper that could be held inside money market mutual funds were instituted as a result. Nevertheless, these instruments are becoming increasingly available to retail investors through online outlets sponsored by financial subsidiaries.

Commercial paper usually pays a higher rate of interest than guaranteed instruments, and the rates tend to rise along with national economic growth. Some financial institutions even allow their customers to write checks and make transfers online with commercial paper fund accounts in the same manner as a cash or money market account.

However, investors need to be aware that these notes are not FDIC-insured. They are backed solely by the financial strength of the issuer in the same manner as any other type of corporate bond or debenture. Standard &Poor’s and Moody’s both rate commercial paper on a regular basis using the same rating system as for corporate bonds, with AAA and Aaa being their highest respective ratings. As with any other type of debt investment, commercial paper offerings with lower ratings pay correspondingly higher rates of interest. But there is no junk market available, as commercial paper can only be offered by investment-grade companies.

Commercial Paper Defaults

As a practical matter, the Issuing and Paying Agent, or IPA, is responsible for reporting the commercial paper issuer's default to investors and any involved exchange commissions. Since commercial paper is unsecured, there is very little recourse for investors who hold defaulted paper, except for calling in any other obligations or selling any held stock of the company. In fact, a large default can actually scare the entire commercial paper market. Many commercial paper issuers purchase insurance as a form of backup.

Defaults are more common than in past years. Prior to the financial crisis of 2007-08, commercial paper issuers in the U.S. defaulted on approximately 3% of their issues. That number rose sharply in 2007-08. In fact, the outstanding amount of commercial paper dropped by around 29% by September 2008 for fear of continued default.

One famous example of commercial paper default took place in 1970 when the transportation giant Penn Central declared bankruptcy. The company defaulted on all of its commercial paper obligations. The immediate consequence was that its creditors lost their money. There was so much Penn Central commercial paper floating around that the entire commercial paper market took a hit. Issuers who had no relation to Penn Central saw investors lose confidence in the instrument altogether. The commercial paper market declined by nearly 10% within a month. After this debacle, the practice of buying backup loan commitments as a form of insurance for commercial paper became commonplace in the market.

Trading in Commercial Paper

It is possible for small retail investors to purchase commercial paper, although there are several restrictions that make it more difficult. Most commercial paper is sold and resold to institutional investors, such as large financial institutions, hedge funds, and multinational corporations. A retail investor would need access to very large amounts of capital to buy and own commercial paper; otherwise, indirect investment is possible through mutual funds, exchange-traded funds (ETFs) or a money market account administered and held at a depository institution.

Factors such as regulatory costs, the scale of investable capital, and physical access to the capital markets can make it very difficult for an individual or retail investors to buy and own commercial paper.

For example, commercial paper is typically sold in round lots totaling $100,000. This threshold in itself makes buying commercial paper generally exclusive to institutional investors and wealthy individuals. Further, broker-dealers issuing commercial paper on behalf of a client have pre-existing relationships with institutional buyers that make the market efficient through large purchases of primary offerings. They would not be likely to look to individual investors as a source of capital to fund the transaction.

Commercial Paper Rates and Pricing

The Federal Reserve Board posts the current rates being paid by commercial paper on its website. The FRB also publishes the rates of AA-rated financial and non-financial commercial paper in its H.15 Statistical Release daily weekdays Monday through Friday at 4:15 p.m. The data used for this publication are taken from the Depository Trust & Clearing Corporation (DTCC), and the rates are calculated based on the estimated relationship between the coupon rates of new issues and their maturities.

Additional information on rates and trading volumes is available each day for the previous day’s activity. Figures for each outstanding commercial paper issue are also available at the close of business every Wednesday and on the last business day of every month.

Types of Commercial Paper

There are generally four types of commercial paper: promissory notes, drafts, checks, and certificates of deposit (CDs).

1. Promissory notes: A promissory note is a written promise to pay a certain sum of money to a specified person or entity on a specific date or on demand, and is the most common form of commercial paper. Promissory notes are often used in commercial transactions as a way for one party to borrow money from another party.
2. Drafts: A draft is a written order directing a bank to pay a specified sum of money to a designated person or entity. There are two types of drafts: sight drafts, which are payable when presented to the bank, and time drafts, which are payable at a later date.
3. Checks: A check is a written order directing a bank to pay a specified sum of money to a designated person or entity. Checks can be either personal checks, which are issued by individuals, or cashier's checks, which are issued by banks.
4. Certificates of deposit (CDs): A certificate of deposit is a type of time deposit offered by banks and other financial institutions. It is a promise to pay the depositor a fixed sum of money on a specific date in the future. CDs typically have fixed maturities and fixed interest rates.

Advantages and Risks of Commercial Paper

There are several advantages to using commercial paper as a source of funding. One advantage is speed; commercial paper can be issued quickly, making it a good option for companies that need to raise funds on short notice. Another advantage is flexibility; companies can use commercial paper to raise funds for a variety of purposes, including working capital, financing inventory, and refinancing debt. Additionally, commercial paper tends to have lower costs than other types of short-term borrowing, such as bank loans, and can help companies demonstrate their financial stability and creditworthiness to potential investors, potentially improving their overall credit rating.

However, there are also some risks to consider when using commercial paper. These include credit risk, where the issuer of the commercial paper may default on its payment obligations; interest rate risk, where the value of commercial paper may fluctuate in response to changes in interest rates; liquidity risk, where commercial paper may not be easily traded or sold; and regulatory risk, where commercial paper is not subject to the same level of regulatory oversight as other types of securities, increasing the risk of fraud or other misconduct by issuers.

Example of Commercial Paper

Say that a company needs to raise funds to finance a new product line. The company has a strong credit rating and a good track record of financial performance, so it decides to issue commercial paper to raise the necessary capital.

It works with a financial institution to issue $10 million in commercial paper with a maturity of 180 days and an interest rate of 2%. The company uses the proceeds from the sale of the paper to fund the development and production of the new product line. As the paper matures, the company repays the investors the principal amount plus the agreed-upon interest.

This process allows the company to quickly and efficiently raise the funds it needs to finance its new product line without having to take on additional debt or equity.

The Bottom Line

Commercial paper is a way for companies to raise short-term capital to fund its ongoing operations and overhead. It is also becoming increasingly available to retail investors from many outlets. Those who seek higher yields will likely find these instruments appealing due to their superior returns with modest risk. For more information on commercial paper, contact your financial advisor or visit the Federal Reserve Board website.