What is a Commercial Paper?
A commercial paper refers to a short-term, unsecured debt obligation that is issued by financial institutions and large corporations as an alternative to costlier methods of funding. It is a money market instrument that generally comes with a maturity of up to 270 days.
A commercial paper pays a fixed interest rate to the holder. Also, it is generally sold at a discount to its face value due to the somewhat risky nature of the unsecured security. The need for commercial paper often arises due to corporations facing a short-term need to cover their expenses.
A commercial paper is often referred to as an unsecured promissory note, as the security is not supported by anything other than the issuer’s promise to repay the face value at the maturity date specified on the note. The issuer also must maintain the pre-specified interest payments throughout the duration of the debt.
- Commercial paper is a short-term, unsecured debt instrument with a duration of 1-270 days.
- Financial institutions and large corporations are the main issuers of commercial paper because they have high credit ratings. There is trust in the market that they will repay unsecured promissory notes of this nature.
- Commercial paper is usually sold at a discount to its face value and is a cheaper alternative to other forms of borrowing.
Risks of Commercial Paper
1. Credit rating
It is important to note that due to the promissory nature of the commercial paper, only large corporations with high credit ratings will be able to sell the instrument at a reasonable rate. Such corporations are what is colloquially defined as “blue-chip companies” and are the only ones that enjoy the option of issuing such debt instruments without collateral backing.
If a smaller organization were to try to issue commercial paper, it is quite likely that there would not be enough trust on the part of investors to buy the securities. The credit risk, which can be defined as the likelihood that a borrower is unable to repay the loan, will be too high for smaller organizations, and there will be no market for this type of issue.
Another potential risk of commercial paper, although less relevant than with other, longer-term debt instruments, is that of liquidity. Liquidity generally refers to the ability of a security to be converted into cash at a price that reflects its fair value. That is to say, liquidity reflects how easily a security can be bought or sold in the market.
In the case of commercial paper, liquidity is less of a concern than credit (default) risk as the debt matures quite rapidly, leaving little room for additional trading on secondary markets. For this reason, such secondary markets are quite small, despite the issue being one of the most used money market debt instruments.
A real-world example would be that a large corporation, take Microsoft Corp., would like additional low-cost funding to launch a new research and development program. At this point, the company’s leadership would weigh their options and possibly conclude that commercial paper is a more attractive source of capital than taking out a line of credit with a financial institution.
In such a situation, Microsoft will be leveraging its status as an established business with a high credit rating to issue an unsecured debt instrument, such as commercial paper, and in the process lowering its cost of capital. `
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: