Commercial Paper: A Primer

In the previous articles, we have discussed that the money market has various sub-sections. One of the most important sub-markets is the commercial paper market. The commercial paper market accounts for a sizeable amount of funds that flow through the money market. In this article, we will have a closer look at the details of the commercial paper market.

What is Commercial Paper?

Commercial paper can be defined as a promissory note which is generally issued by private parties. These notes are unsecured meaning that they do not have any collateral. Also, the tenure of these notes is very less. By definition, any short-term debt with a maturity of fewer than 270 days is called commercial paper. However, in reality, most of the commercial papers have a maturity of fewer than 30 days.

Commercial paper generally does not bear any interest. This means that the note is sold at a discount from their face value. Also, the notes are sold in multiples of large sums of money. It is common for commercial paper to be sold in multiples of $100000 in the United States. As a result, there are almost no retail investors in the commercial paper market.

Who Issues Commercial Paper?

The commercial market is a large and very liquid market in the United States and also in other parts of the world. It is common for commercial paper markets to have a market capitalization of more than a trillion dollars!

Commercial paper is generally issued by private corporations. These private corporations can be further sub-divided into financial and non-financial corporations based on the nature of their business.

Both financial, as well as non-financial firms, tend to issue commercial paper. However, financial firms tend to issue these papers in larger numbers. Commercial paper is seen as a mechanism used by banks and other non-banking financial companies to raise funds from the money market.

Who Buys Commercial Paper?

Even though only private companies act as issuers in the commercial paper market, government entities can participate as an investor. It is common for the state as well as local governments to park their excess funds in the commercial paper market. State-owned pension, as well as insurance companies, also use commercial paper to a large extent.

Private investment companies such as money market mutual funds are the biggest investors in the commercial paper market. Private insurance companies and pension funds also use the commercial paper market to park their money in the short run.

Finally, the treasury department of blue-chip corporations which tend to have excess funds in the short run is also an active participant in the money market. These corporations can either be involved in financial business or non-financial business.

Why do Companies Issue Commercial Paper?

The commercial paper market is thriving in most parts of the world. This is largely because issuers derive several benefits by issuing commercial paper. Some of these benefits have been listed below:

1. Commercial paper is used by corporations to meet their short-term funding needs. Commercial paper tends to be much more cost-effective when the expenses related to other alternatives such as bank overdrafts are considered.

2. It is common for issuers of commercial paper to roll over their debt. This means that they just issue new commercial paper and use the proceeds to pay off the previously issued commercial paper. This means that even though the commercial paper is technically ultra-short-term in nature, it is possible for companies to deploy the funds for a longer period of time.

3. One possible alternative to commercial paper is the issue of short-term bonds. However, issuing short-term bonds can be prohibitively expensive and time-consuming when the entire process is taken into account. Companies have to spend a large amount of time trying to ensure that they have provided proper disclosures and other criteria which are laid out by exchanges.

   The process of issuing commercial notes is comparably quite hassle-free. There is very little paperwork that needs to be filled before the commercial paper is issued. This is largely because of the fact that no retail investors are involved due to the high transaction size.

   Only accredited investors are allowed to purchase commercial paper. Hence, the regulators do not have to protect the interests of the common man. They assume that investors who borrow using commercial paper are aware of the risks.

4. In certain countries such as the United States, there are certain tax advantages provided to issuers when they use commercial papers to raise money in the short run.

5. Commercial papers can be easily sold using a dealer network. There are many corporations that issue commercial paper on a daily basis. They have a dealer network set up which sells these securities to other investors. Under normal circumstances, this system works seamlessly.

   However, if the company issuing the commercial paper has faced any negative credit events in the recent past, then the dealer network may be skeptical in selling the securities. In such cases, companies have to resort to borrowing from banks till they can get the issues related to the negative credit event sorted out.

6. Lastly, even though commercial papers are unsecured, the interest rates on these securities tend to be lower when compared to bank loans, overdrafts, or bond issues.

The bottom line is that the commercial paper market is a significant component of the overall money market. Many different types of companies are involved in issuing as well as buying money market securities since they obtain significant benefits by doing so.