Commercial paper — concise explainer
Definition
– Commercial paper is an unsecured, short-term debt instrument issued by corporations to raise cash for near-term needs (payroll, accounts payable, inventory). “Unsecured” means it is not backed by collateral. Typical issues are in minimum denominations of $100,000, and maturities run from 1 day up to 270 days (average roughly 30 days).
Quick historical note
– Short-term trade obligations have existed for centuries. In modern U.S. markets, dealers began buying and reselling such notes in the 19th century; Marcus Goldman (founder of Goldman Sachs) was an early and important dealer.
Main uses
– Finance operating needs that will be covered within a short period (current assets), such as paying suppliers or employees.
– Provide short-term funding at lower cost than some other financing when the issuer has strong credit.
Key features and market facts
– Unsecured: Most commercial paper is not secured by assets (asset-backed commercial paper, ABCP, is an exception and is backed by specific assets).
– Issuer quality: Only firms with strong credit ratings typically issue commercial paper, because buyers rely on issuer creditworthiness.
– Denominations and buyers: Issues are usually $100,000 or larger and are purchased by corporations, financial institutions, money-market desks, and wealthy investors.
– Typical maturities: 1 to 270 days (very short-term; rarely more than 270 days so as to avoid registration requirements).
Types of short-term instruments often grouped with or related to commercial paper
– Promissory note: A written promise by the issuer to pay a set amount on a specified date. Sold at a discount and redeemed at face value; the difference is interest.
– Drafts: Order to pay drawn on a drawee (often a bank); can be payable on demand (sight) or at a future date (time draft).
– Bankers’ acceptances: Time drafts that a bank accepts (guarantees); commonly used in trade finance and can be resold before maturity.
– Certificates of deposit (large-denomination CDs): Bank-issued time deposits with fixed interest and a set term
Pricing and yield conventions
Commercial paper is typically quoted using money-market conventions rather than standard bond coupon math. Three common measures:
– Bank discount yield (BDY): used historically for T-bills and sometimes quoted for CP. BDY = (Face − Price) / Face × (360 / Days to maturity). This measures the discount as a fraction of face value on a 360-day year.
– Money-market (CD-equivalent) yield (MMY): converts the discount into a yield based on funds actually invested. MMY = (Face − Price) / Price × (360 / Days to maturity).
– Effective annual yield (EAY): the true annualized return, accounting for compounding. EAY = (1 + (Face − Price) / Price)^(365 / Days to maturity) − 1.
Example (worked numeric)
Issuer sells $1,000,000 face-value CP maturing in 90 days. Dealer quotes a bank-discount rate such that Price = $990,000 (so Discount = $10,000).
1) BDY = (10,000 / 1,000,000) × (360 / 90) = 0.01 × 4 = 0.04 → 4.00%.
2) MMY = (10,000 / 990,000) × (360 / 90) = 0.010101 × 4 = 0.040404 → 4.0404%.
3) EAY = (1 + 10,000 / 990,000)^(365 / 90) − 1 = (1.010101)^(4.0556) − 1 ≈ 0.0416 → 4.16%.
Note: BDY understates the investor’s return because it scales discount to face value rather than invested capital. Always check which convention is being used.
Issuance process and market participants
– Issuers: large corporations, financial firms, and sometimes municipalities use CP for short-term funding (payroll, receivables gaps). Issuers often run a CP program approved by a board and maintain an issuing agent (dealer).
– Dealers: broker/dealers buy CP from issuers and place it with investors. They provide market-making and pricing.
– Investors: money market mutual funds, corporate treasuries, banks, and institutional cash managers are the main buyers.
– Credit support: many programs use backup lines of credit from banks to improve liquidity; some CP is asset-backed (ABCP) with specific collateral.
– Regulation and filing: most CP under 270 days is exempt from SEC registration under Rule 144A and other exemptions; programs still provide offering materials and periodic disclosures.
Credit and liquidity risks
– Unsecured: commercial paper is generally unsecured (no collateral). Its credit risk depends on the issuer’s short-term creditworthiness and, often, the availability of bank lines.
– Rollover risk: issuers rely on the ability to issue new paper at maturity. Market-wide dislocations can prevent refinancing, forcing use of backup lines or more expensive funding.
– Liquidity risk for investors: secondary market liquidity can be limited; many investors hold to maturity.
Historical note
During the 2007–2009 financial crisis, asset-backed commercial paper (ABCP) markets experienced freezes as investors pulled back, highlighting rollover and liquidity risks. Central banks and government entities later provided emergency facilities to stabilize CP markets.
Checklist for analyzing a commercial paper issue (for institutional or educational use)
1. Confirm maturity (days) and whether the issue is ≤270 days.
2. Check quoted convention: BDY, MMY, or price. Convert to the yield measure you use.
3. Review issuer credit rating (Moody’s, S&P, Fitch) and recent rating actions.
4. Verify existence and terms of any backup bank lines or liquidity facilities.
5. Understand use of proceeds and whether CP is unsecured or asset-backed.
6. Assess secondary-market liquidity and minimum investment/denomination.
7. Compare yield to alternatives (Treasuries, CDs, repo) on a consistent yield basis (use MMY or EAY).
8. Note settlement and tax conventions.
Practical example: yield comparison (step-by-step)
Suppose a money market fund can buy 90-day CP priced at $995 per $1,000 face. To compare to a 90-day Treasury quoted at a 3.80% bank-discount yield:
1) CP: Discount = 5; BDY_CP = (5/1000) × (360/90) = 0.02 → 2.00%.
MMY_CP = (5/995) × (360/90) = 0.020202 × 4 = 0.080808 → 8.0808% (this numeric shows why be careful—ensure numbers are consistent; re-check price and days).
(When doing real comparisons, plug accurate prices and avoid mixing up decimals.)
Practical tips and caveats
– Always convert yields to the same convention before comparing instruments.
– Be mindful of day-count conventions (360 vs
365) because that changes annualization. Also check settlement (trade date vs settlement date) and tax status (taxable vs tax-exempt) before comparing yields.
Worked example — corrected step‑by‑step
Assumptions: face value = $1,000; price = $995; maturity = 90 days.
1) Compute the dollar