Commercial paper

Commercial paper (CP) is an unsecured short-term instrument of debt, issued primarily by corporations, banks and other financial institutions to help meet the financing requirements of their accounts receivable (debtors), inventories (stock) and other short-term cash needs, but can also be issued by municipali­ties.

Called ‘paper' because originally the promissory note was written on a piece of paper, CP is now more usually dealt with electronically, but is still a promise to pay the holder the designated sum on the designated date. Buyers include money market funds, investment firms, mutual funds, insurance companies, pension funds, governments and banks. Also corporations with temporary surpluses of cash are able to put that money to use by lending it directly to other commercial firms at a higher effective rate of interest than they might have received by depositing the funds in a bank. Investors in CP often buy it from dealers, which are usually banks. Settlement (actual transfer) is normally the same day as the deal is struck (known as T+0).

One of the advantages of CP is its flexibility in terms of maturity. While it has an average maturity of about 40 days, with the normal range being from 30 to 90 days, it can be 270 days in the US and up to a year in some other countries. Normally CP is issued at a discount rather than the borrower being required to pay interest - thus the face value (amount paid on redemption) will be higher than the amount paid for the paper at issuance.^[25] The discount, and the yield gained by the lender, tends to be higher than that for T-bills because there is a greater risk of default and because there is less liquidity in the secondary market.

This source of finance is in general available only to the most respected corporations with the highest credit ratings given the absence (usually) of assets pledged to be used to pay the obligation should the borrower fail to do so by other means. Most commercial paper is issued and traded among institutions in denominations of $100,000 or more, but some is issued in smaller denominations.

Large and frequent borrowers may pay issuance costs of merely one or two basis points. Some companies, such as General Electric, are such frequent issuers of CP that they employ in-house teams to do the selling - direct placement. Other issuers ask dealers (usually employed by investment banks) to either buy the issue with the expectation of selling it on (firm commitment underwrit­ing) or use ‘their best endeavours' to find lenders. These two methods are dealer-directed offers.