What Is A Commercial Paper?

It is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing market interest rates.

It is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price.

A commercial paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.

Commercial paper is typically sold in lots of $100,000 and sometimes in lots of $25,000. This is why most of the investment in this sector is from institutions, banks, and other large agencies. Most commercial paper is sold through financial companies such as automobile manufacturers; this is done through "captive financing". 

There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market.

The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies. Most of these firms also are dealers in US Treasury securities. Direct issuers of commercial paper usually are financial companies that have frequent and sizable borrowing needs and find it more economical to sell paper without the use of an intermediary.

In the United States, direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized, which translates to $50,000 on every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the United States.

Commercial paper yields

Commercial paper is typically a discount instrument, like the zero coupon bond, and sold at a deep discount to par, or its maturity value. The spread between the purchase price and the maturity value is the interest payment. Yields are typically higher than their treasury equivalent for the obvious reasons; they have credit risk associated, they are taxable at the state level (while treasuries are not), and they are not as liquid of an investment as treasuries.