Commercial Paper Explained: Definition, Benefits, and Practical Example

Adam Hayes, Ph.D., CFA, is a seasoned financial writer with over 15 years of experience on Wall Street as a derivatives trader. Beyond his deep expertise in derivatives, Adam specializes in economics and behavioral finance. He earned his master's degree in economics from The New School for Social Research and a Ph.D. in sociology from the University of Wisconsin-Madison. Adam holds a CFA charter and FINRA Series 7, 55 & 63 licenses. Currently, he conducts research and teaches economic sociology and financial social studies at Hebrew University in Jerusalem.

What Is Commercial Paper?

Commercial paper is an unsecured, short-term debt instrument issued by corporations to meet their immediate funding needs. It is commonly used to cover short-term liabilities such as payroll, accounts payable, and inventory purchases. Typically, commercial paper is issued in denominations of $100,000 or more, with maturities ranging from 1 to 270 days, averaging around 30 days. This instrument is sold at a discount and redeemed at its full face value upon maturity.

Key Insights

• Commercial paper represents unsecured, short-term borrowing.
• Corporations use it to finance short-term expenses like payroll and inventory.
• Maturity periods vary between 1 and 270 days, commonly around 30 days.
• Issued at a discount, it pays the face value at maturity.
• Minimum investment is typically $100,000, with interest rates influenced by market conditions.

Historical Background of Commercial Paper

Originating during colonial times as bills of exchange, commercial paper evolved in the 1920s when New York merchants started selling short-term obligations to dealers to raise capital for immediate needs. These dealers purchased promissory notes at discounts and resold them to banks and investors. The merchants repaid the investors the full par value upon maturity.

Unlike asset-backed commercial paper (ABCP), commercial paper is unsecured and not backed by collateral, typically resulting in higher yields. Only corporations with strong credit ratings issue commercial paper, allowing them to attract buyers without offering steep discounts.

Large institutions, financial firms, and affluent individuals commonly purchase commercial paper, which is issued in large denominations starting at $100,000.

Interesting Fact

Marcus Goldman, founder of Goldman Sachs, was a pioneering dealer in commercial paper, becoming one of the largest dealers in America post-Civil War.

Various Types of Commercial Paper

Corporations issue different forms of commercial paper based on their financing needs. Key types include:

Promissory Notes

Written commitments to pay a specified sum by a certain date, promissory notes allow companies to borrow without collateral. They are sold at a discount and redeemed at face value, with maturities ranging from a few days to a year.

Drafts

Drafts are written orders from one party to another (usually a bank) to pay a third party a specified amount. Used in trade finance, drafts can be payable on demand (sight drafts) or at a future date (time drafts).

Bankers’ Acceptances

These are time drafts guaranteed by a bank, commonly used in international trade to assure exporters of payment. Bankers' acceptances can be traded on secondary markets before maturity.

Certificates of Deposit (CDs)

Issued by banks, CDs pay fixed interest over a set period and are considered low-risk due to bank backing. Large-denomination CDs are often grouped with commercial paper because of their liquidity and short-term nature.

Repurchase Agreements (Repos)

Repos involve selling securities with an agreement to repurchase them later at a predetermined price. These secured transactions function as short-term loans in money markets.

Key Terms of Commercial Paper

• Issuer: Usually large corporations with strong credit profiles issuing short-term debt to cover immediate cash needs.
• Term/Maturity: Duration the debt is outstanding, typically up to 270 days, often around 30 days.
• Secured/Unsecured: Generally unsecured, meaning no collateral backs the debt, relying on issuer creditworthiness.
• Discount/Face Value: Issued at a discount and redeemed at face value, with the difference representing interest.
• Liquidity: Enhances issuer liquidity for short-term needs; investors hold it as a liquid asset.

Note

While similar to bonds, commercial paper has distinct characteristics, such as shorter maturities and no periodic interest payments.

Benefits and Drawbacks of Commercial Paper

Advantages

• No SEC registration required for maturities under 270 days.
• Cost-effective and straightforward financing method.
• Less complex than obtaining bank loans.
• Lower interest rates with minimal default risk.
• Offers portfolio diversification for investors.

Disadvantages

• Only issuable by companies with excellent credit ratings.
• Funds must be used for current assets or inventory, not fixed assets without SEC approval.
• Offers relatively low returns to investors.
• High minimum investment limits accessibility for smaller investors.

Who Issues Commercial Paper?

Large, creditworthy corporations across various industries issue commercial paper to cover short-term funding gaps. For instance, manufacturers may use it to finance raw material purchases, while service firms might issue it to fund payroll before earning revenue.

Who Buys Commercial Paper?

Primary buyers are institutional investors such as money market funds, corporate treasuries, pension funds, and insurance companies seeking liquidity and low risk. Banks also invest in commercial paper to align asset-liability durations.

Commercial Paper vs. Bonds

Although both are debt instruments, commercial paper is short-term (1 to 270 days) and unsecured, with no coupon payments, while bonds are longer-term (1 to 30 years), often secured, and pay periodic interest.

Example of Commercial Paper in Action

A retail company needing $10 million for holiday inventory issues commercial paper with a face value of $10.1 million. Investors pay $10 million upfront and receive $10.1 million at maturity, earning a 1% interest over 30 days.

Is Commercial Paper a Type of Debt?

Yes, it is a short-term, unsecured debt instrument used by companies to quickly raise capital without the complexities of traditional loans.

Primary Buyers of Commercial Paper

Due to high minimum denominations, large institutions such as investment firms, retirement accounts, and government entities are the main purchasers.

How Can Individuals Invest in Commercial Paper?

Smaller investors can access commercial paper indirectly through money market funds, mutual funds, or ETFs that invest in these instruments.

Maturity Periods for Commercial Paper

Typically ranging from 1 to 270 days, common maturities are 30, 60, and 90 days, balancing risk and liquidity for issuers and investors.

Risks of Commercial Paper

The main risk is credit risk — the possibility the issuer defaults. Since commercial paper is unsecured, investors depend heavily on the issuer's creditworthiness.

Conclusion

Commercial paper is a practical, short-term unsecured debt tool for creditworthy companies to meet immediate financial needs at lower costs than loans. While offering modest returns to investors, it provides liquidity and diversification, making it a valuable component of many investment portfolios.

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