What is Commercial Paper?

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Definition:

Commercial paper is an unsecured short-term debt instrument that financial institutions and other companies may use to raise capital.

🤔 Understanding commercial paper

When companies want to raise capital to pay for operating expenses such as inventory and payroll, they might use commercial paper to do so. Commercial paper is a type of short-term debt that companies can issue, with maturity schedules of 270 days or fewer. This type of debt security can be an attractive choice for the issuing entity, as it's often a more affordable alternative to getting a loan from a bank. Financial institutions and corporations often issue commercial paper. The investors in commercial paper are usually money market mutual funds, which invest in short-term debt securities. Commercial paper can be good for investors, as it often yields a greater return than government-backed debt securities such as Treasury bonds and Treasury bills. The trade-off is that, as with any investment, commercial paper has its fair share of risk.

Example

Suppose that the fictional tech company Vitality & Tech is planning to launch a new smartwatch before Black Friday. The company knows it’s going to get a lot of sales of the watch, but wants to raise a bit of capital to fund the extra inventory upfront. Vitality & Tech issues $5M in commercial paper to pay for the new smartwatches. The maturity date of the debt is six months out, which is when the company will pay back its lenders with interest. The commercial paper allows Vitality & Tech to borrow money — Likely for a more affordable rate than if it took out a loan from a bank.

Takeaway

Issuing commercial paper is like renting an apartment on Airbnb...

When you stay at an Airbnb, you’re basically paying to borrow someone else’s space for a few days. When your reservation ends, you hand the keys back over to the owner. Commercial paper is similar, in that issuers are paying to borrow money from investors for a short period of time, and then handing it back over when the debt instrument reaches maturity. The rent that the Airbnb tenant pays to borrow the space is akin to the interest that a commercial paper issuer pays to investors.

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What is commercial paper?

Commercial paper is a type of short-term debt security that corporations issue to raise money for immediate costs. The issuers of commercial paper are most often financial institutions such as commercial and investment banks. Commercial paper is usually an unsecured debt, meaning the issuers don’t put up any sort of collateral (which is an asset the lenders can seize if the borrower defaults). Despite that, commercial paper is still a generally low-risk investment due to the high credit rating and healthy balance sheets of the issuing companies.

What are the features of commercial paper?

One important feature of commercial paper is that they’re discount securities. Investors buy the commercial paper for less than the face value. When the investment reaches maturity, the investor gets the full face value. The difference between the purchase price and the face value is the interest the investor receives (aka the discount).

It’s usually financial institutions that issue commercial paper. The commercial paper that these financial companies issue is unsecured, which means there’s no collateral backing it up (collateral is an asset that a lender can seize if a borrower defaults on debt). Instead, the companies are usually large, successful corporations with healthy balance sheets and high credit ratings. Because of this, commercial paper is still generally considered low-risk.

What is the commercial paper market?

The commercial paper market refers to the transactions where investors buy and sell these debt securities. The commercial paper market isn’t like your local food market where you walk in and peruse the different choices available. Instead, individual investors primarily get into this market by putting cash in money market mutual funds, which often invest in commercial paper.

What are the types of commercial paper?

Per the Uniform Commercial Code, which is the set of laws that governs commercial transactions, there are four types of commercial paper.

A draft is a three-party transaction where one party (the drawer) orders another party (the drawee) to pay a particular sum of money to a third party (the payee) at a particular time.

A check is basically a type of draft, with payment on demand. Common bank checks, certified checks, and cashier’s checks all fall under this category.

A certificate of deposit (CD) is an investment vehicle at a bank in which consumers can put their money and receive a higher interest rate than a traditional savings account, as long as they leave their money for a particular period.

A promissory note is a written promise that one party makes to another to give them a particular amount of money at a particular time. When we talk about commercial paper as a debt security, we’re generally referring to promissory notes.

What is the difference between commercial paper and bonds?

Like commercial paper, a bond is a debt security that corporations and governments issue to raise money. The two investment vehicles differ in a few ways.

First, commercial paper has a maturity date of less than 270 days (though most often less than 45). Bonds, on the other hand, can have maturity periods ranging from just one year to more than a decade.

Additionally, while commercial paper comes with just one payment for the investor when the security matures, bond issuers make interest payments to bondholders twice per year.

Who can issue commercial paper?

Large companies issue commercial paper to raise capital for short-term spending. Most issuers include companies such as:

  • Commercial banks that accept deposits and lend money to consumers
  • Investment banks that offer services to corporations
  • Industry companies such as General Electric, General Motors, and PepsiCo

The issuers of commercial paper don’t have to put up collateral for these debts. As a result, companies issuing these debt securities must generally have a high credit rating and the trust of investors.

Who can buy commercial paper?

The two biggest investors of commercial paper are money market mutual funds and commercial banks. These two types of investors hold about half of all outstanding commercial paper. Other investors include life insurance companies, pension funds (a type of retirement account that many government entities offer), and corporations outside the financial sector. Just about anyone can be an investor in commercial paper by putting money into a money market mutual fund that invests in these debt securities.

What are commercial paper interest rates?

The interest rate (aka the discount rate) for commercial paper is the difference between the amount an investor pays for the debt security and the face value that he or she will get when the paper reaches maturity. Rates may vary depending on whether you’re investing in financial or nonfinancial commercial paper.

As of May 26, 2020, the rate for a 3-month commercial paper from a financial company with a credit rating of AA was 0.15%. The rate of a commercial paper from a nonfinancial company with the same rate for the same period was 0.25%.

What is the maturity period of commercial paper?

Under the Securities Act of 1933, securities available to the public have to be registered with the Securities and Exchange Commission (SEC). Commercial paper is generally exempt from this law, as long as it meets specific rules. One factor that allows commercial paper to avoid registration with the SEC is a maturity period of less than 270 days. While this is the longest maturity that commercial paper can have, most actually have maturities of between five and 45 days.

What are the advantages and disadvantages of commercial paper?

Commercial paper can be a low-risk investment choice for those who want to diversify their portfolios. The rate of return is generally higher than what you’d get from your run-of-the-mill savings account. And the risk is far lower than putting your money into the stock market. There have been very few defaults on commercial paper over the years, partially stemming from the fact that the companies issuing these debt securities usually have a high credit rating.

Despite their advantages, there are clear downsides as well. First, commercial paper is a type of unsecured debt. So while default is extremely rare, that doesn’t mean it’s impossible. As with any investment, there’s an inherent risk of losing your money.

Another downside to commercial paper is the rate of return. While it can be an effective way to diversify a portfolio, you may not want to invest all your money there to grow wealth. In the 10-year period leading up to 2020, the United States saw an average inflation rate of 1.77%. During that same period, the average return on commercial paper from a financial institution was less than half a percent. So had you invested all your money into one-month commercial paper during that time, you actually would have lost money when accounting for inflation.

How was commercial paper used during the financial crisis?

Before the 2007 financial crisis, investors often used commercial paper as a safe place to park their money due to the high credit rating of the issuers and the short maturity dates. It was the largest short-term debt security on the market, with $1.97T in outstanding debt, mostly in the financial sector.

The tides started to turn in late 2007 when two hedge funds owned by Bear Stearns (an investment bank) filed for bankruptcy. The company prevented investors from pulling out of its funds, which were invested in subprime mortgages. Out of fear that a similar fate would come to commercial paper investments, investors stopped putting their money into them. The amount of outstanding commercial paper investments dropped by 37%.

More than one year later, a money market mutual fund that had invested into the Lehman Brothers’ (another investment bank) commercial paper suffered significant losses. This event triggered investors to pull their money from money market funds. The Federal Reserve had to step in to insure the lost money and to buy commercial paper for the first time in history.

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New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.