Commercial paper
Encyclopedia
In the global money market
, commercial paper is an unsecured
promissory note
with a fixed maturity
of 1 to 270 days. Commercial Paper is a money-market security
issued (sold) by large bank
s and corporation
s to get money
to meet short term debt
obligations (for example, payroll
), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral
, only firms with excellent credit rating
s from a recognized rating agency
will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount
from face value, and carries higher interest repayment rates than bond
s. Typically, the longer the maturity on a note, the higher the interest
rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.
, a set of non-federal business laws
adopted by all 50 U.S. State
s except Louisiana.
At the end of 2009, more than 1,700 companies in the United States
issue commercial paper. As of 2008 October 31, the U.S. Federal Reserve reported seasonally adjusted figures for the end of 2007: there was $1.7807 trillion (short-scale
, or 1,780,700,000,000) in total outstanding commercial paper; $801.3 billion was "asset backed" and $979.4 billion was not; $162.7 billion of the latter was issued by non-financial corporations, and $816.7 billion was issued by financial corporations.
, got his start trading commercial paper in New York in 1869.
investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market. The dealer market for commercial paper involves large securities
firms and subsidiaries of bank holding companies. Most of these firms also are dealers in US Treasury securities
. Direct issuers of commercial paper usually are financial companies that have frequent and sizable borrowing needs and find it more economical to sell paper without the use of an intermediary. In the United States, direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized, which translates to $50,000 on every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the United States.
with a bank. Once a business becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a "backup". Banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, in some cases companies in serious trouble may not be able to repay the loan resulting in a loss for the banks.
Advantage of commercial paper:
Disadvantages of commercial paper:
icp(dy) = [(Pf - P0)/Pf] x (360/h)
and when converted to a bond equivalent yield:
icp(bey) = [(Pf - P0)/P0] x (365/h)
on high quality commercial paper are rare, and cause concern when they occur. Notable examples include:
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
, commercial paper is an unsecured
Unsecured debt
In finance, unsecured debt refers to any type of debt or general obligation that is not collateralised by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment....
promissory note
Promissory note
A promissory note is a negotiable instrument, wherein one party makes an unconditional promise in writing to pay a determinate sum of money to the other , either at a fixed or determinable future time or on demand of the payee, under specific terms.Referred to as a note payable in accounting, or...
with a fixed maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
of 1 to 270 days. Commercial Paper is a money-market security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
issued (sold) by large bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s and corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
s to get money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
to meet short term debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
obligations (for example, payroll
Payroll
In a company, payroll is the sum of all financial records of salaries for an employee, wages, bonuses and deductions. In accounting, payroll refers to the amount paid to employees for services they provided during a certain period of time. Payroll plays a major role in a company for several reasons...
), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
, only firms with excellent credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
s from a recognized rating agency
Credit rating agency
A Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount
Discounts and allowances
Discounts and allowances are reductions to a basic price of goods or services.They can occur anywhere in the distribution channel, modifying either the manufacturer's list price , the retail price , or the list price Discounts and allowances are reductions to a basic price of goods or services.They...
from face value, and carries higher interest repayment rates than bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
s. Typically, the longer the maturity on a note, the higher the interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.
Overview
As defined by Article Four of the Uniform Commercial CodeUniform Commercial Code
The Uniform Commercial Code , first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America.The goal of harmonizing state law is...
, a set of non-federal business laws
Commercial law
Commercial law is the body of law that governs business and commercial transactions...
adopted by all 50 U.S. State
U.S. state
A U.S. state is any one of the 50 federated states of the United States of America that share sovereignty with the federal government. Because of this shared sovereignty, an American is a citizen both of the federal entity and of his or her state of domicile. Four states use the official title of...
s except Louisiana.
At the end of 2009, more than 1,700 companies in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
issue commercial paper. As of 2008 October 31, the U.S. Federal Reserve reported seasonally adjusted figures for the end of 2007: there was $1.7807 trillion (short-scale
Long and short scales
The long and short scales are two of several different large-number naming systems used throughout the world for integer powers of ten. Many countries, including most in continental Europe, use the long scale whereas most English-speaking countries use the short scale...
, or 1,780,700,000,000) in total outstanding commercial paper; $801.3 billion was "asset backed" and $979.4 billion was not; $162.7 billion of the latter was issued by non-financial corporations, and $816.7 billion was issued by financial corporations.
History
Commercial paper, in the form of promissory notes issued by corporations, have existed since at least the 19th century. For instance, Robert Gadd, founder of Goldman SachsGoldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, got his start trading commercial paper in New York in 1869.
Issuance
There are two methods of issuing paper. The issuer can market the securities directly to a buy and holdBuy and hold
Buy and hold is a long-term investment strategy based on the view that in the long run financial markets give a good rate of return despite periods of volatility or decline. This viewpoint also holds that short-term market timing, i.e...
investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market. The dealer market for commercial paper involves large securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
firms and subsidiaries of bank holding companies. Most of these firms also are dealers in US Treasury securities
Treasury security
A United States Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States federal government, and they are often referred to simply as Treasuries...
. Direct issuers of commercial paper usually are financial companies that have frequent and sizable borrowing needs and find it more economical to sell paper without the use of an intermediary. In the United States, direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized, which translates to $50,000 on every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the United States.
Line of credit
Commercial paper is a lower cost alternative to a line of creditLine of credit
A line of credit is any credit source extended to a government, business or individual by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of...
with a bank. Once a business becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a "backup". Banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, in some cases companies in serious trouble may not be able to repay the loan resulting in a loss for the banks.
Advantage of commercial paper:
- High credit ratings fetch a lower cost of capital.
- Wide range of maturity provide more flexibility.
- It does not create any lien on asset of the company.
- Tradability of Commercial Paper provides investors with exit options.
Disadvantages of commercial paper:
- Its usage is limited to only blue chip companies.
- Issuances of Commercial Paper bring down the bank credit limits.
- A high degree of control is exercised on issue of Commercial Paper.
- Stand-by credit may become necessary
Commercial Paper Yields
Like Treasury Bills, yields on commercial paper are quoted on a discount basis—the discount return to commercial paper holders is the annualized percentage difference between the price paid for the paper and the par value using a 360-day year. Specifically:icp(dy) = [(Pf - P0)/Pf] x (360/h)
and when converted to a bond equivalent yield:
icp(bey) = [(Pf - P0)/P0] x (365/h)
Defaults
DefaultsDefault (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
on high quality commercial paper are rare, and cause concern when they occur. Notable examples include:
- On June 21, 1970, Penn Central defaulted on a debt of $77.1 million
- The Federal Reserve intervened and cut Penn Central's bond rating from BBB to Bb. This placed a substantial burden on clients of the issuing dealer for Penn Central’s commercial paper, Goldman Sachs.
- On January 31, 1997, Mercury Finance, a major automotive lender, defaulted on a debt of $17 million, rising to $315 million.
- Effects were small, partly because default occurred during a robust economy.
- On September 15, 2008, Lehman BrothersBankruptcy of Lehman BrothersLehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. The bankruptcy of Lehman Brothers remains the largest bankruptcy filing in U.S...
caused two money fundMoney fundA money market fund is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are widely regarded as being as safe as bank deposits yet providing a higher yield...
s to break the buck, and led to Fed intervention in money market funds.
External links
- Federal Reserve System release on commercial papers
- Commercial paper - Encyclopedic entry
- An article from The Times on commercial paper and credit market vernacular
- CP Daily - Premium provider of research and searchable databases relating to global CP and ECP markets.
- Stepek, John. What's wrong with commercial paper? MoneyWeekMoneyWeekMoneyWeek is a weekly investment magazine that covers financial and economic news and provides commentary and analysis across UK and global markets...
, August 31, 2007 - How the subprime crisis has affected the commercial paper market - What is Commercial Paper? - Mortgage News Daily
- Fed Bank of Richmond, VA - History of origin, and special regulations governing issue of commercial paper. Thomas K Hahn, Federal Reserve Bank of Richmond
- The Week America's Economy Almost Died National Public RadioNPRNPR, formerly National Public Radio, is a privately and publicly funded non-profit membership media organization that serves as a national syndicator to a network of 900 public radio stations in the United States. NPR was created in 1970, following congressional passage of the Public Broadcasting...
broadcast September 26, 2008.