Commercial paper is a short-term financial instrument issued by banks, corporations, and other borrowers to investors who have temporarily idle cash. These instruments are unsecured and have maturities ranging from 2 to 270 days. They are typically issued at a discount, although some may be interest-bearing. Commercial paper can be issued directly or through brokers, who can handle the substantial clerical work involved.
Characteristics of Commercial Paper
Maturity
Commercial paper typically has a short maturity period ranging from 2 to 270 days. This flexibility in maturity terms makes them appealing both to issuers and investors.
Unsecured Nature
Commercial paper is generally unsecured, meaning it is not backed by collateral. This makes the creditworthiness of the issuer a crucial factor in the issuance and acceptance of commercial paper.
Discounted vs. Interest-Bearing
Most commercial papers are issued at a discount to their face value and are redeemed at face value upon maturity. However, some commercial papers are interest-bearing, offering periodic interest payments.
Issuance
Commercial paper can either be issued directly to investors by the borrowers (direct issuance) or through brokers who manage the administrative tasks involved (brokerage issuance).
Advantages of Commercial Paper
For Issuers
- Flexible Maturities: Issuers can select maturity dates that best fit their needs.
- Lower Rates: Interest rates on commercial paper are usually marginally lower than those of bank loans, making them a cost-effective financing option.
- Volume Management: Issued in large denominations, commercial paper helps manage temporary cash flow imbalances efficiently.
For Investors
- Safety and Security: Typically issued by top-rated entities, commercial paper is considered a low-risk investment, often backed by bank lines of credit.
- Flexibility: Investors can choose from a range of maturities to match their liquidity preferences.
- Higher Yield: Compared to short-term treasury bills and other low-risk investments, commercial paper might offer slightly better returns.
Examples and Applications
- Example 1: A corporation with an excellent credit rating needs to finance inventory for the next three months. It issues commercial paper with a 90-day maturity to raise the necessary funds.
- Example 2: A bank issues commercial paper to manage short-term liquidity requirements, offering a slightly lower interest rate than what it would incur from a commercial loan.
Historical Context
Commercial paper originated in the United States in the mid-19th century as a way for merchants to finance inventory purchases. Over time, the use of commercial paper expanded as more corporations and banks recognized its flexibility and cost-effectiveness. Today, it remains a vital part of the short-term funding landscape for many large institutions.
Comparisons and Related Terms
- Treasury Bills vs. Commercial Paper: Treasury bills are government-issued and considered risk-free, whereas commercial paper is issued by corporations and carries some risk based on the issuer’s creditworthiness.
- Bank Loans vs. Commercial Paper: Commercial paper typically has lower interest rates and shorter maturities compared to bank loans, which can extend for several years.
- Certificate of Deposit (CD) vs. Commercial Paper: CDs are time deposits with banks, often insured and carrying fixed interest rates, while commercial papers are unsecured and can be issued by non-financial entities.
FAQs
Q1: Who can issue commercial paper?
A1: Commercial paper can be issued by banks, corporations, and other financial institutions with high credit ratings.
Q2: Is commercial paper a safe investment?
A2: Commercial paper is generally considered safe if issued by top-rated entities, often backed by bank lines of credit. However, it is still unsecured, so it carries some risk.
Q3: What denominations are commercial paper issued in?
A3: Commercial paper is usually issued in large denominations, often starting from $100,000 or more.
Q4: How is the interest rate on commercial paper determined?
A4: The interest rate is influenced by the issuer’s credit rating, market demand, and overall economic conditions.
Q5: Can individuals invest in commercial paper directly?
A5: Typically, commercial paper is issued in large denominations and is more accessible to institutional investors than individual retail investors.
References
- “Commercial Paper,” Investopedia.
- “The Handbook of Fixed Income Securities,” by Frank J. Fabozzi.
- “Principles of Corporate Finance,” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen.
Summary
Commercial paper plays a critical role in short-term financing for corporations and banks. Its unsecured nature, combined with flexible maturities and generally lower interest rates, makes it an attractive option for both issuers and investors. Understanding the nuances of commercial paper can aid in making informed investment and financing decisions.
