What is Commercial Paper? Types and Benefits Explained

Published on : September 25, 2024

When businesses need a quick, efficient, and low-cost way to raise funds, they often opt for commercial paper. Commercial paper is a short-term, unsecured debt instrument that’s both efficient and cost-effective for businesses. It’s fast, flexible, and generally issued by well-established corporations to cover payroll, inventory, or other short-term liabilities.

But what exactly is commercial paper, and why do companies choose it?

What is Commercial Paper?

Commercial paper is a short-term financial instrument that companies use to meet immediate financial needs, such as covering daily operational expenses. It was introduced in India in 1990 to offer businesses an alternative source of raising funds, particularly for companies with high credit ratings.

Companies with strong credit ratings are able to issue commercial paper, as investors place significant trust in the issuer’s financial stability. Since commercial paper is an unsecured form of financing, the issuing company does not provide any assets as collateral to guarantee repayment, making the issuer’s financial health an important factor for investors.

It usually needs to be paid back to the investor within 270 days, with many companies choosing to repay it between 15 to 45 days. Commercial paper is of two types: bearer notes, which are physical documents, and registered notes, which are tracked electronically under the investor’s name.

Features of Commercial Paper

Here are some features of commercial paper that make it a popular option for both issuers and investors:

1. Low Cost

It’s generally cheaper for companies to issue commercial paper than to borrow money in other ways, like through bonds, because there are fewer regulations and shorter time frames involved.

2. High Returns

The interest rates on commercial paper are often higher than what you would get from savings accounts, offering investors a potentially much better investment option.

3. Flexibility

Companies can use the funds from commercial paper for various purposes, including financing working capital, refinancing existing debt, or investing in new projects.

4. Low Risk

Commercial papers are mostly issued by financially stable companies with good credit ratings. This reduces the risk for investors compared to other types of investments.

5. Tax Benefits

In some cases, the interest earned on commercial paper may qualify for preferential tax benefits that investors may prefer.

6. Liquidity

Investors can easily sell their commercial paper before it matures, allowing them to access their money quickly if needed.

7. Ease of Access

Investors can often purchase commercial paper directly from brokers or issuers, making it easy to invest.

8. Regulatory Oversight

it is checked by the Securities and Exchange Commission (SEC), providing an added layer of protection for investors and issuers alike.

9. Unsecured Debt

Commercial paper is considered unsecured debt, as it is not backed by collateral. Investors base their decisions on the issuing company’s financial health and income-generating ability.

10. Diversification

Adding commercial paper to an investment portfolio can help spread out risk, as its performance often doesn’t closely follow stocks or bonds.

Types of Commercial Paper

Each type of commercial paper has unique benefits and risks, and investors can choose according to their specific financial objectives and risk tolerance.

Here are the main types of commercial paper:

1. Drafts

Drafts, or bills of exchange, are formal orders in which the drawer directs the drawee to pay a designated amount to the payee. These instruments are commonly used as a payment or fund transfer method, particularly in international trade transactions.

2. Promissory Notes

Promissory notes are formal agreements in which the issuer commits to paying a specific sum to the payee by a set date. These legally binding documents structure loans or debts between individuals, businesses, or financial institutions.

3. Receivable-Backed Commercial Paper

This type of commercial paper is secured by accounts receivable, which may include invoices for goods or services already provided.

4. Asset-Backed Commercial Paper (ABCP)

Asset-Backed Commercial Paper is a type of commercial paper secured by a pool of underlying assets such as receivables or loans. This provides security for investors, as the assets can be sold to pay back the debt if the issuer defaults.

5. Certificates of Deposit (CDs)

Certificates of Deposit (CDs) are time-bound deposits provided by banks and financial institutions. Investors place a set amount of money for a fixed duration, earning interest at a predetermined rate. CDs are viewed as low-risk investments because they offer guaranteed returns and ensure the repayment of the initial deposit at maturity.

6. Letter of Credit (LOC)

An LOC is a document from a bank that guarantees payment for goods or services, even if the buyer can’t pay. It’s commonly used in international trade to ensure sellers receive their money.

7. Structured Notes

Structured notes are complex investments tied to the performance of other assets like stocks or bonds. The return investors get depends on how those underlying assets perform.

8. Registered Notes

These notes represent ownership of commercial paper and are officially recorded in the buyer’s name. This makes them more secure and easier to track.

Advantages and Disadvantages of Commercial Paper

Here are some of the advantages and disadvantages of commercial paper

Advantages of commercial paper:

1. Low Risk: Commercial paper is generally issued by companies with strong credit ratings, making it a low-risk investment for those looking to invest in financially stable businesses.
2. Short-Term Investment Option: Commercial paper has a maturity period of less than 270 days, making it a good choice for investors who prefer short-term investments. This allows investors to have access to their capital relatively quickly.
3. High Liquidity: Since it is traded in the secondary market, investors can easily buy or sell commercial paper, providing them with flexibility if they need to convert their investment into cash.

Disadvantages of commercial paper:

1. Unsecured Debt: Commercial paper does not require pledging any collateral, which means that if the issuing company defaults, investors could potentially lose their investment. 

2. Lower Returns: The returns on commercial paper are usually lower compared to other types of investments, such as stocks or corporate bonds. This makes it less attractive for investors looking for high returns.

3. Market Dependence: The cost of commercial paper is influenced by overall market conditions. During periods of financial instability, companies may face higher borrowing costs when using this financing option.

Commercial Paper vs Bonds

When companies need to borrow money, they can do so by offering commercial paper or bonds. Let’s look at the difference between commercial paper and bonds.

Feature	Commercial Paper	Bonds
Purpose	Short-term borrowing for companies	Long-term borrowing for companies or governments
Maturity Period	Up to 270 days	1 to 30+ years
Collateral	Unsecured (no collateral)	Usually secured by collateral or backed by guarantees
Risk Level	Low risk (if issued by highly rated companies)	Lower risk due to collateral or guarantees
Yield (Returns)	Higher returns than bonds for short-term investors	Lower returns but offers stable, long-term income
Liquidity	High liquidity (shorter duration, easy to sell)	Lower liquidity (longer duration, difficult to exit early)
Investor Profile	Ideal for investors seeking quick, higher returns	Ideal for investors seeking stable, long-term income

Conclusion

From an investment perspective, commercial paper provides businesses with a flexible and cost-effective option for raising short-term funds without the need for collateral. Its unsecured structure appeals to investors seeking relatively low-risk, short-term returns while offering companies quick access to capital to support their immediate financial goals. For investors, it can serve as a reliable, liquid asset with competitive interest rates compared to other short-term investments.

Frequently Asked Questions

Who can issue commercial paper?

Commercial paper can be issued by only financially stable and creditworthy corporations, financial institutions, and certain government entities. These issuers must have a strong credit rating since the debt is unsecured, meaning it isn’t backed by collateral.

What happens when commercial paper matures?

Upon maturity, the issuing company must repay the face value of the commercial paper to the investor. Companies may issue new commercial paper to roll over the debt or pay it off using internal funds or other financing methods.

Is commercial paper a good option for all businesses?

No, commercial paper is generally suited for large, creditworthy corporations. Smaller businesses or those without a strong credit rating may not qualify to issue commercial paper and would need to explore alternative financing options like business loans.

How is commercial paper traded?

Commercial paper is usually traded in the money market through over-the-counter (OTC) transactions between institutional investors, such as banks, mutual funds, and pension funds. It is not generally traded on public exchanges.

What is the maturity period of commercial paper?

The maturity period of commercial paper is between 1 to 270 days. The issuer decides the duration based on their immediate financing needs, and investors choose the paper that best matches their investment strategy.