Commercial paper is a type of unsecured debt that businesses issue to raise funds because they tend to be a cheaper form of borrowing than bank loans.
What Is Commercial Paper?
Commercial paper is a type of debt issued by a company that can serve as a source of funding for its operations. Money raised from commercial paper can be used to meet short-term needs, such as payroll, inventory finance, or payment for raw materials. Companies often prefer commercial paper to bank loans, which tend to carry higher interest rates.
Commercial paper is a type of unsecured debt, which means it isn’t backed by assets or other types of collateral. Instead, issuers have lines of credit from banks to back the debt. Just as a person’s eligibility for a credit card is based on their credit score, a company’s ability to issue commercial paper is based on its creditworthiness.
In the commercial paper market, the company issuing the debt is usually perceived to be low risk. Still, ratings agencies such as Moody’s and Fitch issue credit ratings on the commercial paper to be sold as a measure of potential investment for prospective buyers. The typical issuer of commercial paper is a large corporation with a strong credit rating.
How Long Does Commercial Paper Take to Mature?
Commercial paper can have a maturity as short as overnight or as long as 270 days. The duration is significant because any debt with a maturity exceeding 270 days must be registered with the Securities and Exchange Commission (SEC). So, a company issuing millions of dollars in commercial paper doesn’t have to face the scrutiny of the SEC if their debt matures in 270 days or fewer. Since commercial paper has a duration of less than a year, it is recognized as a liquid asset.
The average duration of a commercial paper is 30 days, according to the Federal Reserve. That being said, it is common for companies to roll over their commercial paper when they are due by issuing new paper.
A Brief History of Commercial Paper
Commercial paper reportedly originated in the U.S. in the 1700s, and its widespread use as a debt facility gained traction in the 1800s when businesses—typically requiring funds for inventory—started issuing promissory notes on paper.
Investment banking giant Goldman Sachs traces its origin and prominence in the commercial paper market to founder Marcus Goldman, who first sold promissory notes in 1869. He built up relations with small business owners such as wholesale jewelers and leather merchants in Lower Manhattan and helped them issue commercial paper based on their creditworthiness.
In the first year of operations, as an intermediary between borrowers and institutional lenders, he led transactions totaling $5 million (the equivalent of $111 million in 2023). In the 1970s, Goldman Sachs was the biggest dealer in the U.S. commercial paper market.
While commercial paper is largely unsecured debt, some corporations use assets—such as receivables—as collateral, and this is known as asset-backed commercial paper (ABCP). It typically has maturity durations of 90 to 180 days. Transactions of ABCPs picked up in the 1990s, and these helped to push the value of the U.S. commercial paper market up to a record $2.2 trillion in July 2007.
Transactions for ABCPs declined during the financial crisis of 2007–2008 because ABCPs were used to fund longer-term asset-backed securities, of which their credit ratings were questionable, and issuers had difficulty rolling over their debt as the market for those securities collapsed. The Federal Reserve Board temporarily set up a commercial paper funding facility (CPFF) on October 27, 2008, to address liquidity concerns by buying commercial paper.
Fed data showed that the outstanding value of U.S. commercial paper exceeded $1.25 trillion at the end of 2022. (In comparison, the total value of the U.S. debt market was about $30 trillion.) Still, the commercial paper market is up from about $951 million in late 2020, during the height of the COVID-19 pandemic. The Fed for the second time opened up the CPFF on March 17, 2020, for the purchase of commercial paper during the pandemic. This was a way to keep money flowing into the economy by allowing companies that might be distressed to raise funds. The CPFF stopped buying commercial paper a year later.
Who Are the Important Participants in the Commercial Paper Market?
There are generally three major players in the commercial paper market: those who issue, those who purchase, and those who deal.
These are corporations and financial institutions. Typically, the bulk of commercial paper issuance comes from banks and finance companies that are raising funds. Sovereign governments also sell commercial paper from time to time.
Investors include mutual funds, foreign corporations, pension funds, and state and local governments that seek to diversify their holdings.
Typically, the biggest investment banks and securities firms deal the commercial paper because they have clients who both sides of the transaction: buyers and sellers. There is no official list of commercial paper dealers as there is for primary dealers of government debt. When the Fed set up the CPFF, most of the commercial dealers listed were also primary dealers.
How Is Commercial Paper Issued, Sold, Purchased & Redeemed?
A company seeking to sell commercial paper does so through a dealer that serves as an intermediary between it and the dealer’s clients, the buyers. For example, an automobile manufacturer wants to raise $50 million to pay bonuses to management on what is expected to be a record quarter in sales. It can’t get money quick enough, so the automaker turns to commercial paper for immediate funding and wants to pay the face value of the paper in 90 days. A dealer works with the issuer to set the discount rate and finds buyers. Investors buy the commercial paper but must wait 90 days to receive their money back, with interest.
The dealer makes money from the transaction by buying the commercial paper from the debtor and selling it at a higher price to investors, pocketing the difference. Thus, commercial paper rates tend to be a bit higher than Treasuries with similar maturities to account for the dealer’s profit.
Commercial paper works like fixed-income investments but tends to have rates higher than Treasuries with similar maturities, and even higher than bank savings deposit rates.
How Are Interest Rates on Commercial Paper Calculated?
When a company issues commercial paper that is due, for example, in 270 days, the company agrees to pay back the face value at the end of 270 days. It sells the commercial paper at a discount, or below par value, and it buys the paper back at face value. The difference is the interest earned by the investor (and the price paid by the issuer for the temporary use of the buyer’s funds).
What Are the Differences in Commercial Paper Internationally?
The U.S. has the biggest market in commercial paper, and is designated abroad as U.S. commercial paper (USCP). While other countries may have their own commercial paper market, commercial paper issued internationally is known as Eurocommercial paper (ECP), but the debt can be in any currency denomination. The other big markets for commercial paper are in Canada and the U.K.
Eurocommercial doesn’t face the scrutiny of the SEC and isn’t limited by the 270-day maturity duration that would trigger oversight. Typically, the length of maturity for Eurocommercial paper can be as long as 364 days, or less than a year.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about commercial paper.
What Are the Differences Between Commercial Paper and Bonds?
Unlike bonds, which can be redeemed at any time, investors in commercial paper must wait to be paid out at maturity. Like most types of bonds, taxes must be paid on any interest earned.
Who Are the Biggest Issuers of Commercial Paper?
Banks and finance companies are among the biggest issuers of commercial paper.
Who Are the Biggest Holders of Commercial Paper?
Money market mutual funds, corporations, and state and local governments are among the biggest holders of commercial paper.
What Is Asset-Backed Commercial Paper?
Some companies use assets as collateral for their commercial paper offerings, and this is known as asset-backed commercial paper. Its maturity durations are typically 90 to 180 days.
What Is Credit-Supported Commercial Paper?
Credit-supported commercial paper is typically backed by a bank, which agrees to pay the face value of the debt if the issuer does not.