What is Commercial Paper?
• Commercial paper, in the global money market, is an unsecured promissory note that possesses a fixed maturity of 1 to 270 days.
• Commercial paper is a type of money-market investment security sold by large financial institutions and corporations to raise money in order to meet various short term debt obligations (such as payroll). Commercial paper is only backed by an issuing financial institution or company’s promise to pay the face amount when the commercial paper reaches its maturity date.
• Because commercial paper is not backed by collateral, only companies with excellent credit ratings (credit score must be issued by a recognized credit agency) will be able to sell their commercial paper at a fair price.
• Commercial paper is typically sold at a discount from face value; in addition to the discount, commercial paper will also carry a higher interest repayment rate than the maturity of bonds. In the majority of instances, the longer the maturity on a note, the higher the interest rate the issuing company or financial institution is required to pay.
Who issues Commercial Paper?
• In the beginning of 2010, more than 1,700 American companies issued commercial paper. The United States federal Reserve reported the following statistics regarding commercial paper at the end of 2009: there was over $1.7 trillion in total outstanding commercial paper; over $800 bullion was regarded as “asset backed” and nearly $trillion was not; roughly $162 billion of the non-asset backed commercial paper was issued by non-financial corporations and nearly $817 billion was issued by financial corporations.
What are the Advantages and Disadvantages of Commercial Paper?
• Commercial paper is low cost alternative compared to obtaining a line of credit with a bank. When a business establishes itself and achieves a high credit rating, it is typically cheaper to draw on a commercial paper than pursuit a line of credit from a bank. That being said, a number of companies will still maintain bank lines of credit as “backup.”
• The following characteristics are regarded as advantages for commercial paper:
Commercial paper are only issued to companies with high credit ratings; higher credit ratings always fetch a lower cost of capital
Commercial paper is offered with a wide range of maturity, which provides more flexibility
Commercial paper does not create any liens on assets of the company
The tradability of Commercial paper provides investors with exit options
• The following characteristics are regarded as disadvantages of Commercial Paper:
The usage of commercial paper is typically limited to blue chip companies or those businesses that possess excellent credit ratings
The issuance of Commercial Paper decreases bank credit limits
A high degree of control is exercised on issue of Commercial paper
Stand-by credit may become necessary to obtain commercial paper.