Commercial Papers

Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Commercial Paper?

Commercial Paper is defined as a money market instrument that is used for obtaining short-term funding and is usually in the form of a promissory notePromissory NoteA promissory note is defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date.read more issued by investment-grade banks and corporations. Most commercial papers are easily rolled over by paying for old issuance from the proceeds of new issuances. Hence it becomes a continuous source of funding.

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Commercial Papers (wallstreetmojo.com)

The discount at which the instrument is issued results in the rate of return on commercial paper. After the 2008 crisis, investors lost their confidence in this instrument, particularly asset-backed ones, but the same has now been restored. As a result, these papers are widely issued and invested in.

Key Takeaways

  • Commercial papers (CPs) are short-term debt instruments corporations, financial institutions, and governments issued to meet short-term financing needs. They are typically unsecured promissory notes with maturities ranging from a few days to 270 days.
  • CPs are commonly issued by well-established and creditworthy entities with a strong market reputation. Investors in commercial papers include institutional investors such as money market funds, corporations, and individuals seeking short-term investments with relatively low risk.
  • Due to their short maturity, CPs usually have lower interest rates than longer-term debt instruments. 

Commercial Paper Explained

Commercial paper is a negotiable instrumentNegotiable InstrumentA negotiable instrument refers to the transferrable and signed written document whereby the payer guarantees or promises to pay a certain sum on a specific future date or as on-demand to the payee or bearer. It includes bills of exchange, delivery order, promissory note, customer receipt, etc.read more issued to get short-term credit. There are certain rules and restrictions on issuances, issuers, and investors. It is usually unsecured but, at times, backed by financial assets.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Investments in such securities are made by institutional investors and high net worth individuals (HNI) directly & by others through mutual funds or exchange-traded funds (ETF).

The asset backed commercial paper is not meant for the general public, and hence, there is a restriction on the advertisement to market the securities. A secondary market also exists for commercial papers, but the market players are mostly financial institutions.

It is issued at a discount to the face value, and upon maturity, the face value becomes the redemption value. It is issued in large denominations, e.g., $100,000.

There is no need to register the papers with the Securities Exchange Commission (SEC), and hence, it helps in saving the administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more and results in lesser filings.

The commercial paper market stood at $7.2 billion for the financial sector and $23 billion for the non-financial sector as of April 2019 month end as per Fed reserve. Most of the issuances of asset backed commercial paper are done in a 1-4 days bracket as per Fed reserve. A total of 112 issues were done in April 2019, and out of those, 47 issues were related to the 1-4 days bracket.

Interest rates during April 2019 were ranging from 2.39% to 2.47% for institutions with AA rating and 2.46% to 2.56% for others as per Fed reserve.

Types

Let us look at the various types of commercial papers available in the financial market.

#1 -Uniform Commercial Code – UCC

Commercial Papers

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Commercial Papers (wallstreetmojo.com)

As per the Uniform Commercial Code (UCC), commercial papers are of four kinds:

  1. Draft – A draft is a written instruction by a person to another to pay the specified amount to a third party. There are 3 parties in a draft. The person who gives the instructions is called a “drawer.” The person who is instructed is called “drawee.” The person who has to receive the payment is called the “payee.”
  2. Check – This is a special form of the draft where the drawee is a bank. There are certain special rules which apply to a check. Hence this is considered to be a different instrument.
  3. Note – In this instrument, a promise is made by one person to pay another a certain sum of money to another. There are 2 parties in a note. The person who makes the promise and writes the instrument is called a “drawer” or “maker.” The person to whom the promise is made and to whom payment is to be made is called “drawee” or “payee.” It is also known as a “promissory note.” In most instances, a commercial paper is in the form of a promissory note.
  4. Certificates of Deposit (CD) – A CD is an instrument wherein the bank acknowledges the receipt of deposit. Further, it also carries details about maturity value, interest rate, and maturity date. It is issued by the bank to the depositor. It is a special form of the promissory note. There are certain special rules which apply to a CD. Hence this is considered to be a different instrument.

#2-On The Basis of Security

On the basis of security, there are two types of commercial paper issuance:

  1. Unsecured Commercial Papers – These are also known as traditional commercial papers. Most of these papers are issued without any collateral, and hence, they are unsecured. The rating of the issue depends upon the asset quality and all other aspects relating to that organization. Rating is done in the same manner in which it is done for the bonds. These are not covered by the deposit insurance, e.g., Federal Deposit Insurance Corporation (FDIC) insurance in the U.S., and hence, investors obtain insurance from the market separately as a backup.
  2. Secured Commercial Papers – These commercial paper issuance are also known as Asset-backed commercial papers (ABCP). These are collateralized by other financial assets. These are normally issued by creating a Structured Investment vehicle that is set up by the sponsoring organization by transferring certain financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more. These papers are issued to keep off the instruments from the financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more of the sponsor organization. Further, the rating agencies rate the issue on the basis of the assets kept in the Structured Investment Vehicle, ignoring the asset quality of the sponsor. During the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, ABCP holders were one of the biggest loss-makers.

Yield

Formula for Yield of Commercial Paper are as given below:

Yield = (Face Value – Sale Price/ Sale Price) * (360/Maturity Period) * 100

The yields on this financial instrument id typically lower than any other form of short term debt instrument. This amount is determined based on the market rates that are prevailing, the issuer’s credit rating and maturity of the documents. If the issuer has a very high rating, they offer lower yield because investment in those commercial papers are considered to be safer than issuers having lower rating.

Pricing

Formula for Pricing Commercial Paper:

Price = Face Value / [1+(Yield/100 * Maturity Period/360)]

Maturity Period

It is important to be knowledgeable about the maturity period of this type of debt instrument before investing in investing in commercial paper.  The maturity of commercial paper ranges from 1 to 270 days (9 months), but usually, it is issued for 30 days or less. Some countries also have a maximum duration of 364 days (1 year). The higher the duration, the higher, is the effective rate of interest on these papers.

However, it is interesting to note that the maturity impacts the pricing of the instruments. Moreover, longer maturity means higher yields because they are perceived to be riskier compared to short term instruments.

Examples

Let us understand the concept of investing in commercial paper with the help of some examples.

Example #1

Calculate the interest yield of the following commercial paper:

  • Face Value: $500,000
  • Sale Price: $490,000
  • Maturity period: 100
  • Brokerage and Other charges: 3%

Solution:

  • Brokerage = 3% of $500,000 = $15,000
  • Net Sale Price = $495,000 – $15,000 = $475,000

The calculation for Yield is as follows –

Commercial Papers Yield Example 1-1
  • Yield = [(Face Value – Sale Price)/Sale Price] * (360/Maturity Period) * 100
  • = (500,000 – 475,000)/475,000 * (360/100) * 100
  • = 18.95%

Example #2

Calculate the market price of the following example of commercial paper:

  • Face Value: $500,000
  • Yield (after brokerage): 20%
  • Maturity period: 100

Solution:

The calculation for Pricing is as follows –

Commercial Papers Pricing Example 1-1
  • Price = Face Value / [1+{(Yield/100)*(Maturity Period/360)}]
  • = 600,000 / [1+(20/360)]
  • = $568,421

Advantages

Some of the advantages of the financial debt instrument is given below.

  1. No collateral is needed.
  2. Lower cost of funding.
  3. Lesser documentation and compliance.
  4. Highly liquid.
  5. It allows the diversification of funds in short-term instruments.
  6. High-rated instruments, hence fewer chances of default.
  7. For investors, returns are higher as compared to bank deposits.
  8. No restriction on the end-use of funds.
  9. The commercial paper market is growing, and most of the investments are through prime money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more funds (MMF).

Disadvantages

Along with the advantages, commercial paper funding facility is also necessary to look at the disadvantages of the investment opportunity.

  1. Commercial paper can be issued by investment-gradeInvestment-gradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more banks and large corporations only. Hence it is not a source of funds which is available to all.
  2. Small investors cannot directly invest in commercial paper.
  3. The secondary market for commercial papers is less liquid.

Commercial Paper Vs Bonds

Both the financial instruments given above are used for debt. However, let us find out the differences between them.

  • The former is issued by corporations, financial institutions whereas the latter is issued by governments, corporations or municipalities.
  • The former carries risk because they are unsecured and depends on the credit rating of the issuer, whereas the latter has far lower risk if they are government bonds, but also depends on the issuer’s credit rating.
  • The maturity of the former is short, ranging from few days to nine months, but maturity of the latter is for long term,ranging from a few years to decades.
  • Both the commercial paper funding facility and bonds are traded in secondary market actively.
  • The interest rates offered by the former is typically higher than the latter because they have a higher risk involved. For bonds the interest may be fixed or floating and is determined during issuance.  
  • Commercial papers are mainly available to institutional investors whereas the certificate of deposits are available to individuals or institutional investors.

Thus, the above are some important differences between the debt instruments.

Frequently Asked Questions (FAQs)

1. How are commercial papers rated?

Commercial papers are assigned ratings by credit rating agencies based on the issuer’s creditworthiness. These ratings reflect the agency’s assessment of factors such as the issuer’s financial strength, repayment ability, and overall creditworthiness. Higher-rated commercial papers are considered less risky and typically offer lower yields.

2. Can individual investors invest in commercial papers?

While commercial papers are primarily targeted toward institutional investors, individual investors can gain exposure to them through money market funds, mutual funds, or exchange-traded funds (ETFs) that invest in short-term debt instruments. These investment vehicles provide individual investors with access to the commercial paper market.

3. What are the risks associated with investing in commercial papers?

Although commercial papers are generally considered low risk, there are still risks to be aware of. The primary risks include credit risk, as the issuer may default on repayment, and liquidity risk, as secondary market trading volume can be limited for certain commercial papers. It’s important for investors to carefully evaluate the creditworthiness of issuers and consider the liquidity of the specific commercial papers they are investing in.

Recommended Articles

This has been a guide to what is Commercial Paper. We explain it with examples, maturity, differences with bonds, types, advantages, disadvantages & yield. Here are the other articles in accounting that you may like –

Reader Interactions

Comments

  1. Prashantg says

    Good

    • Dheeraj Vaidya says

      Thanks for your kind words!