What is a Commercial Paper?

Published by Thomas Herold in Corporate Finance, Investments

'Commercial Paper' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Commercial paper proves to be a corporation-issued short term form of debt instrument which is unsecured. This paper is generally used to finance such things as inventories, accounts receivable, and other short term liabilities. The maturity dates for commercial paper vary, but they do not typically run any more than 270 days. Such paper instruments are generally issued at discounts to their face value. These discounts take into account the market interest rates that are effective when the company issues its paper.

Because commercial paper does not come with any underlying collateral, it turns out to be unsecured corporate debt. This means that only those companies that boast debt ratings which are highest quality will be able to find takers easily. Other companies must float their paper debt issues at greater discounts. This makes the funds come at a higher cost. Large organizations issue these paper instruments in significant denominations of typically $100,000 or higher. The most usual buyers of these paper instruments are banks and financial institutions, other companies, money market funds, and wealthy investors.

Commercial paper offers significant advantages for the corporations who utilize it. One of the biggest is that they do not have to register these offerings with the SEC Securities and Exchange Commission if the paper reaches maturity within 270 days or before nine months pass. This makes it a cost effective and quick way to obtain finance. While companies do have up to 270 days before the SEC is involved, typical maturity time frames for this paper only average around 30 days.

There are some restrictions to the use of commercial paper. It’s funds can only be utilized for current assets and inventories. They may not be employed to purchase fixed assets like new facilities or plants unless the SEC is involved.

The financial crisis that began to erupt in 2007 involved the commercial paper market in a significant way. When investors had fears that major companies like Lehman brothers had problems with their liquidity and financial condition, markets for commercial paper seized up. Companies lost their access to funding which was affordable and simple to obtain.

This market freezing also led to money market funds “breaking the buck.” As major investors in these paper instruments, the funds suffered from the suspect health of firms whose issued paper caused their own fund values to drop below the standard $1. Up to this point, money market funds had been considered risk free for investors. Government backing and guarantees were required to restore order and functionality to these markets.

A company might need additional short time frame funds in order to pay for Christmas holiday season additional inventory. The company could issue paper for $20 million in needs at $20.2 million face value. This means investors will provide it with $20 million in funding and receive $200,000 as interest when the paper matures. It would amount to a 1% interest rate. If the paper is not redeemed at its initial maturity, the interest rate would adjust the amount of principal and interest the paper would return appropriately based on the number of days it remained outstanding.

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The term 'Commercial Paper' is included in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.