What is Commercial Paper?
Commercial Paper is a form of short-term, unsecured debt, most often issued by corporates and financial institutions such as banks.
- What is the definition of commercial paper?
- What are the standard features of commercial paper?
- Which type of companies typically issue commercial paper?
- What is asset-backed commercial paper (ABCP)?
How Commercial Paper Works
Commercial paper is a money market instrument structured as an unsecured, short-term promissory note with a specified amount to be returned by an agreed-upon date.
For corporates, commercial paper is issued for purposes of meeting near-term liquidity needs, or more specifically, short-term working capital needs and expenses like payroll.
Companies often opt to raise capital via commercial paper since they do not have to be registered with the Securities and Exchange Commission (SEC) unless the maturity is longer than 270 days.
Since commercial paper is unsecured (i.e. not backed by collateral), investors must have faith in the issuer’s ability to repay the principal amount as outlined in the loan agreement.
The issuers of commercial paper are predominately large-sized corporations and financial institutions with high credit ratings.
Commercial paper thereby represents a convenient option for qualified companies to access the capital markets without having to go through the tedious SEC registration process.
Commercial Paper Features
Commercial paper is issued by large corporations with strong credit ratings as short-term debt to fund their short-term working capital needs.
The typical commercial paper term is ~270 days, and the debt is issued at a discount (i.e. zero-coupon bond) as an unsecured promissory note.
Traditionally, commercial paper is issued in denominations of $100,000, with the primary buyers in the market consisting of institutional investors (e.g. money market funds, mutual funds), insurance companies, and financial institutions.
The maturities on commercial paper can range from just a handful of days to 270 days, or 9 months. But on average, 30 days tends to be the norm for the maturities of commercial paper.
Similar to treasury bills (T-Bills), which are short-term financial instruments backed by the U.S. government, commercial paper is typically issued at a discount from face value.
Downsides to Commercial Paper
The one downside to commercial paper is that companies are restricted to using the proceeds on current assets, namely inventory and accounts payable (A/P).
More specifically, the cash received as part of the commercial paper arrangement cannot be used to fund capital expenditures (CapEx) – i.e. the purchase of long-term fixed assets (PP&E).
Commercial paper is unsecured, meaning that it is backed merely by investors’ trust in the issuer. In effect, only large corporations with high credit ratings can issue commercial paper at favorable rates and with enough liquidity (i.e. market demand).
Asset-Backed Commercial Paper (ABCP)
One variation of commercial paper is asset-backed commercial paper (ABCP), which is also a short-term issuance but is backed by collateral.
The issuers of ABCP are usually non-bank financial institutions (e.g. conduits) that provide collateral in the form of financial assets such as trade receivables and related payments expected to be received by the issuer in the future.
ABCP tends to be less restrictive and could be used for longer-term spending needs (i.e. CapEx), rather than just short-term liquidity and working capital needs.
Before the Great Recession, ABCP formerly represented a substantial proportion of the money market industry, when it was primarily issued by commercial banks. The creditworthiness of ABCP issuances collapsed, however, due to the collateralization with mortgage-backed securities (MBS), which contributed to the 2008 Global Financial Crisis.
The liquidity crisis that ensued exposed the vulnerabilities in the U.S. money market system, resulting in more strict regulations to be placed and less capital allocated to the ABCP sector.