What Is Commercial Paper?
Commercial Paper Explained
When corporations need to raise money, they often bypass a traditional bank lender and issue debt securities directly to investors. One of the ways they do this is by using “commercial paper.” Commercial paper is a type of unsecured debt that companies issue to raise capital on a short timeline.
Understanding what commercial paper means exploring how they work, what types there are, how they compare to bonds, and what advantages and disadvantages they provide investors.
What Is Commercial Paper?
Commercial paper is a short-term debt security that corporations use to raise capital. Because of their short maturity schedules, companies often use commercial paper to cover immediate expenses such as payroll and inventory. Commercial paper has a maturity of up to 270 days, but the average is about 30 days. The issuers of this type of debt security are most often financial institutions and large corporations.
How Does Commercial Paper Work?
Commercial paper is usually issued in two possible ways. First, the issuer might sell the debt securities directly to investors. They also might sell them to a dealer, who then turns around and sells them.
Companies issue their commercial paper at a discount, meaning you pay less than the face value of the security. Companies typically write commercial paper in minimum denominations of $100,000 with terms ranging from one to 270 days, though the average maturity on commercial paper is around 30 days. The high minimum denominations make them inaccessible for most individual investors but debt investment tools like money-market funds make them more accessible.
Commercial paper pays a fixed interest rate to investors. Like other interest-based investments, the rates tend to fluctuate with the market. In Dec. 2020, the rate on a 90-day non-financial commercial paper loan fell to just 0.11%. This rate is down from 2.18% in March 2020.
Though commercial paper is unsecured, the default risk is relatively low. The issuers are generally creditworthy and well-established, and, in many cases, the paper has a rating from credit rating agencies. Standard & Poor’s, for example, issues credit ratings for commercial paper ranging from AAA (highest) to D (lowest).
Like how you pay interest when you borrow money from a bank, corporations must pay interest to borrow money from investors. Imagine that a corporation wanted to raise $1 million to boost its inventory for the holidays. If the interest rate was 1%, the company would sell commercial paper with a face value of $1,010,000. But the buyer would only pay $1 million. The excess $10,000 would be the interest.
Types of Commercial Paper
A promissory note, sometimes referred to as simply a “note,” is a written promise from one party to another to give them a specific amount of money at a predetermined time. There are only two parties to a promissory note: the payer (company) and payee (you).
A draft is a written agreement with three parties: the drawer (usually the bank), the drawee (the company), and the payee (you). In this type of transaction, the drawer orders the drawee to pay a specific amount of money to the payee.
A check is a specific type of draft where one of the parties (the drawee) is the bank. With this type of transaction, the drawer (company) instructs the drawee to give a sum of money to the payee (you).
While a draft involves the money being remitted at a specific time, a check is paid on-demand.
Certificates of Deposit
A certificate of deposit (CD) is a bank receipt where the financial institution acknowledges it has received a sum of money, and it agrees to pay it back at a specific time in the future. The certificate holds important information such as the interest rate on the commercial paper and the maturity date.
Commercial Paper vs. Bonds
Commercial paper and bonds are similar in many ways. Both are unsecured debt securities that companies can issue to raise capital but the two also have some notable differences.
|Maturity date of 270 days or less, normally||Maturity date of one year to 30 years|
|Issued by corporations||Issued by both corporations and governments|
|One interest payment at maturity||Regular interest payments (usually twice per year)|
Pros and Cons of Commercial Paper
Low risk of default
Allows for portfolio diversification for investors
Affordable short-term capital for companies
Low interest rate
Not a viable funding source for all companies
- Low risk of default: The companies that issue commercial paper are large, creditworthy corporations and the paper often gets ratings from ratings agencies. As a result, there’s a low risk of you losing your investment when you invest in highly-rated commercial paper.
- Allows for portfolio diversification for investors: Debt securities like commercial paper are an effective way for investors to diversify their portfolio and offset higher-risk investments like stocks.
- Affordable short-term capital for companies: For companies, commercial paper serves as an affordable and quick way to get the cash they need for operating expenses and other short-term expenses.
- Unsecured debt: Commercial paper is an unsecured debt, meaning there’s little recourse for the investor if the company defaults. That being said, commercial paper default is quite rare.
- Low interest rate: Commercial paper has a generally low interest rate, meaning investors shouldn’t expect a substantial return. The low interest rate presents an inflation risk, as the return is unlikely to keep up with the rate of inflation.
- Not a viable funding source for smaller companies: Commercial paper is typically only an option for large and extremely creditworthy companies. So, while it can be an excellent affordable funding source, it doesn’t work for all companies.
Is Commercial Paper Worth It?
Investors might find themselves wondering whether commercial paper is really a worthwhile investment. It is true that commercial paper has low rates of return that often don’t even keep up with inflation. In December 2020, the interest rate on a 90-day nonfinancial commercial paper loan was just 0.11%. There are some other factors to consider, however.
The Securities and Exchange Commission recommends that investors practice diversification to help reduce the risk of their portfolio. Because commercial paper has a low default risk, it may do the trick. Other investments such as long-term bonds and even high-yield savings accounts are likely to offer a higher return, especially when rates are low.
How Can Individual Investors Buy Commercial Paper
Commercial paper isn’t as accessible to individual investors as other opportunities might be. That doesn’t mean you can’t invest in them—it just means the path might look a bit different. Commercial paper is often sold directly to institutional investors like money market funds. Individual investors can include commercial paper in their portfolios by investing in money market funds.
Even if companies sold commercial paper directly to individual investors, the $100,000 minimum would likely be too high for the average person. However, high net-worth individuals can purchase commercial paper through a broker who would buy them on your behalf.
- Commercial paper is a type of short-term unsecured debt security issued by financial institutions and other large corporations.
- Commercial paper is sold at a discount, meaning the buyer pays less than the face value of the security, and the rate of return is the difference between the purchase price and face value.
- There are several types of commercial paper, but most come in the form of a promissory note.
- A commercial paper is different from a bond because it has a shorter maturity and can only be issued by companies, whereas both companies and governments can issue bonds.
- Individual investors may include commercial paper in their portfolio by investing in money market funds.