Commercial paper is a short-term loan taken out in the form of IOUs that can be bought and traded – in a similar manner to bonds.
When commercial paper is issued, the maker promises in writing to pay a certain amount of money to the the payee with a final payment date (maturity) of no more than 270 days.
Big corporations often issue commercial paper as a means of receiving money to make short term debt payments.
As commercial paper is not usually backed by any security (assets that act as collateral), only companies with stellar credit ratings can sell their commercial paper at acceptable prices – usually at a discount from face value. Some commercial papers are backed by assets such as loans or mortgages.
Companies commonly sell commercial paper when they need a short-term loan.
According to nasdaq.com, a commmercial paper is a:
“Short-term promissory notes either unsecured or backed by assets such as loans or mortgages issued by a corporation. The maturity of commercial paper is typically less than 270 days; the most common maturity range is 30 to 50 days or less. They are usually sold, like Treasury bills, at a discount.”
The longer the maturity of the paper the higher the interest rate.
For many businesses commercial paper is a cheaper alternative to opening a line of credit with a bank – especially if the business has a good credit rating.
Commercial paper making a comeback in the US
According to the Financial Times, “companies are increasingly raising money by selling commercial paper, breathing new life into a type of short-term debt that all but collapsed in the aftermath of the global financial crisis.”
The US Federal Reserve released a report revealing that the amount of outstanding “non-financial” commercial paper sold by corporations reached $243 billion USD in October 2013 (a 10 year high), and it is forecast to increase.
Vikram Rai and Andrew Hollenhorst, strategists at Citigroup, said the following:
“The growth in non-financial commercial paper has been driven primarily by cheap funding rates, which have caused many non-financial issuers, who have historically relied on bank funding, to turn to the commercial paper markets.”
Chris Conetta, the head of global commercial paper trading at Barclays, said:
“We have seen a lot more interest coming from other corporations. More and more investors have been looking to non-financial commercial paper as a proxy for Treasury bills, agencies and repo, where supply has been declining. There is a shortage of high quality liquid assets at the front end of the credit curve and non-financial paper has helped fill that void.”
Commercial paper defaults
Defaults on high-quality commercial paper are extremely rare, and can trigger semi-panic among investors when they occur.
Penn Central filed for bankruptcy under Chapter 77 of the US Bankruptcy Code in 1970, and defaulted on about $77.1 million of commercial paper. This triggered a runoff in the commercial paper market of nearly $3 billion. The Federal Reserve System (Fed) had to intervene by permitting commercial banks to borrow at a discount.
In 2008, Lehman Brothers caused two money funds to break the buck, and the Fed had to intervene in money market funds.
Video – commercial paper explained
In the video below, Trevor Delaney, Personal Finance Editor at the Associated Press, explains what commercial paper is and why it is so important to the economy: