Economic payment term: Meaning, Criticisms & Real-World Uses

What Is Commercial Paper?

Commercial paper is an unsecured debt instrument issued by large corporations to meet short-term financial obligations. It is a type of promissory note that represents a company's promise to repay a fixed amount on a specific maturity date, typically ranging from a few days to 270 days. As a core component of the money market, commercial paper serves as a vital tool within corporate finance for managing immediate cash flow needs. Corporations frequently issue commercial paper to fund current liabilities such as payroll, inventory, and accounts payable, offering investors a relatively low-risk, short-duration investment.

History and Origin

The origins of commercial paper can be traced back to the 18th century in the United States, with its widespread adoption gaining traction in the 1800s. Early forms involved businesses issuing promissory notes to raise funds for inventory and other short-term needs. Marcus Goldman, the founder of Goldman Sachs, played a significant role in the development and prominence of the commercial paper market, beginning in 1869. He acted as an intermediary, purchasing promissory notes from creditworthy small business owners and then selling these notes to banks and other investors, thereby facilitating short-term financing¹¹. Over time, commercial paper evolved into a premier debt instrument, particularly with the growth of the consumer credit industry in the mid-20th century.

Key Takeaways

Commercial paper is a short-term, unsecured promissory note issued by corporations to cover immediate financial needs.
Its maturity typically ranges from a few days to 270 days, making it exempt from U.S. Securities and Exchange Commission (SEC) registration requirements under certain conditions.
Issued at a discount from its face value, commercial paper generally offers lower interest rates compared to bank loans due to its short duration and the high credit rating of its issuers.
The commercial paper market is a significant segment of the money market, providing large, creditworthy companies with a flexible and cost-effective source of working capital.
Despite its perceived safety, the market can be susceptible to liquidity crises, as demonstrated during the 2007-2009 financial crisis.

Formula and Calculation

Commercial paper is typically sold at a discount rate from its face value, with the difference between the purchase price and the face value representing the interest earned by the investor. The yield to the investor can be calculated using the following formula:

\text{Yield} = \frac{\text{Face Value} - \text{Purchase Price}}{\text{Purchase Price}} \times \frac{360}{\text{Days to Maturity}}

Where:

Face Value: The amount the issuer will pay at maturity.
Purchase Price: The price paid by the investor for the commercial paper.
Days to Maturity: The number of days until the commercial paper matures.
360: A common convention for the number of days in a year in money market calculations.

Interpreting the Commercial Paper

The issuance and yield of commercial paper offer insights into a company's financial health and market conditions. A company's ability to issue commercial paper at favorable interest rates indicates strong liquidity and a high credit rating. Conversely, a rising yield or difficulty in rolling over maturing commercial paper can signal increased default risk or broader market stress. Investors interpret commercial paper yields relative to other money market instruments, such as U.S. Treasury bills, to assess the additional compensation for credit risk. For companies, a consistent presence in the commercial paper market reflects effective treasury management and access to diverse funding sources.

Hypothetical Example

Suppose XYZ Corp. needs $9.9 million for 90 days to cover a large inventory purchase. Instead of taking out a bank loan, they decide to issue commercial paper.

Issuance: XYZ Corp. issues commercial paper with a face value of $10 million and a maturity of 90 days.
Sale to Investor: An institutional investor, Alpha Investments, purchases the commercial paper from XYZ Corp. at a discounted price of $9,900,000.
Use of Funds: XYZ Corp. receives $9,900,000 immediately, which it uses to finance its inventory.
Maturity: After 90 days, XYZ Corp. repays Alpha Investments the full face value of $10,000,000.
Investor Return: Alpha Investments earns $100,000 (the difference between the face value and the purchase price) on its investment. This demonstrates how commercial paper provides efficient short-term financing for the issuer and a predictable return for the investor.

Practical Applications

Commercial paper is widely used by large corporations and financial institutions for various short-term funding needs. Its applications span across several areas:

Working Capital Management: Companies use commercial paper to manage seasonal fluctuations in working capital, funding inventory build-up, accounts receivable, and payroll expenses¹⁰.
Bridge Financing: It can act as a bridge to longer-term financing, allowing companies to raise immediate capital before securing more permanent solutions like bond issuance or bank loans.
Cost-Effective Funding: For highly rated issuers, commercial paper often represents a cheaper alternative to traditional bank lines of credit, reducing overall borrowing costs.
Financial Institution Funding: Banks and other financial entities frequently issue commercial paper, including asset-backed commercial paper (ABCP), to finance various assets, such as credit card receivables and other loan portfolios⁸, ⁹.
Investment Portfolio Management: Money market mutual funds and other institutional investors are major purchasers of commercial paper, seeking low-risk, highly liquid investments with slightly higher yields than Treasury bills⁷.

The total value of commercial paper outstanding in the U.S. market can be monitored through data provided by the Federal Reserve, reflecting its ongoing significance as a source of short-term funding for businesses⁶.

Limitations and Criticisms

While commercial paper offers flexibility and cost advantages, it comes with certain limitations and criticisms:

Credit Quality Dependence: Only companies with high credit ratings can typically access the commercial paper market at favorable rates, limiting its availability to smaller or less creditworthy firms. The unsecured nature of commercial paper means investors rely solely on the issuer's creditworthiness.
Liquidity Risk: The commercial paper market is sensitive to investor confidence. During periods of economic stress or a financial crisis, investors may become unwilling to roll over maturing commercial paper, leading to significant liquidity challenges for issuers. This was prominently observed during the 2007-2009 financial crisis, when the asset-backed commercial paper market experienced a substantial contraction, effectively a "run" as investors pulled funding⁴, ⁵. This event highlighted the potential for systemic risk if the market experiences widespread panic³.
Lack of Collateral: As an unsecured instrument, commercial paper does not offer investors any specific assets as collateral in the event of default, increasing the default risk for investors if the issuer's financial health deteriorates.
Regulatory Scrutiny: Although certain types of commercial paper are exempt from full SEC registration, the market and its participants are still subject to regulatory oversight, particularly concerning disclosures and investor protection². The Securities Act of 1933, Section 3(a)(3), outlines the conditions for this exemption, emphasizing that the paper must arise from current transactions and have a maturity not exceeding nine months¹.

Commercial Paper vs. Corporate Bonds

Commercial paper and corporate bonds are both debt instruments issued by corporations, but they differ significantly in their characteristics and purpose:

Feature	Commercial Paper	Corporate Bonds
Maturity	Short-term, typically less than 270 days	Medium-to-long-term, typically over one year
Nature	Unsecured promissory note	Secured or unsecured debt security
Purpose	Financing short-term needs (e.g., working capital)	Financing long-term projects, capital expenditures
Issuance	Often issued at a discount	Can be issued at par, discount, or premium
Interest	Implicit interest (discount)	Explicit interest payments (coupon)
Registration	Often exempt from SEC registration (under 270 days)	Requires SEC registration
Liquidity	Highly liquid in a well-functioning market	Varies by bond, generally less liquid than CP

The primary distinction lies in their maturity and intended use. Commercial paper is a tool for immediate, short-term funding needs, providing companies with agile cash flow management. Corporate bonds, conversely, are designed for long-term capital raising, funding significant investments and growth initiatives. The regulatory burden is also lighter for qualifying commercial paper due to its short duration, a key reason many large corporations prefer it for short-term financing.

FAQs

Q1: Who issues commercial paper?

A1: Commercial paper is primarily issued by large, financially stable corporations and financial institutions with strong credit ratings. These entities leverage the commercial paper market to efficiently manage their short-term working capital and liquidity needs.

Q2: Why is commercial paper considered a safe investment?

A2: Commercial paper is generally considered low-risk due to its short maturity date (typically under 270 days) and the high credit quality of its issuers. Its short duration minimizes exposure to interest rate fluctuations, and investors often hold it until maturity.

Q3: How does commercial paper differ from a bank loan?

A3: Commercial paper is a direct debt instrument issued by a corporation to investors, often at a discount rate, without involving a bank as the primary lender. A bank loan, conversely, is a direct lending arrangement between a bank and a borrower. For highly rated companies, commercial paper can be a more flexible and cost-effective alternative to traditional bank financing.