You’re sitting in a finance meeting when the topic of commercial paper comes up. You nod along, not wanting to seem ignorant, but find yourself wondering, “What exactly is commercial paper?” Don’t worry, you’re not alone. Many people are fuzzy on the details of this short-term debt instrument that companies use to raise capital.
In this article, we’ll cover everything you need to know about commercial paper. We’ll look at what it is, its key features, the advantages and disadvantages it offers companies. Whether you’re an aspiring finance professional or simply investing in the stock market, understanding commercial paper can empower you to make informed decisions.
What Is Commercial Paper? Definition and Overview
Commercial paper (“CPs”) refers to unsecured, short-term debt instruments issued by companies to meet short-term liabilities. It’s a cheaper alternative to bank loans. Companies issue commercial paper for a fixed period, usually less than 270 days, to raise working capital.
Investors buy the commercial paper, essentially lending money to the issuing company. The company then repays the investors the face value when the paper matures. Commercial paper is a money market instrument, meaning it’s very liquid and low risk.
Companies benefit because the interest rates on commercial paper are lower than on bank loans. Investors benefit from the low risk and short maturity. Commercial paper can be issued by most large companies, but must have a high credit rating to attract investors.
Overall, commercial paper is a win-win for companies and investors alike, providing a source of low-cost financing and a safe, liquid investment option.
Is Commercial Paper a Type of Debt?
Commercial paper is a short-term debt instrument issued by corporations to meet temporary working capital needs. Companies issue commercial paper to raise cash from investors for a short period, typically between a few days up to 270 days. Once issued, the commercial paper can be traded between investors on the secondary market.
Think of commercial paper as an IOU from a company. By purchasing it, you’re lending the company money for a fixed period. The company promises to pay you back your principal plus interest. Unlike long-term corporate bonds, commercial paper matures quickly, so there’s less risk to investors.
For companies, commercial paper is a fast, flexible way to raise cash without the regulatory burden of longer-term debt. The short maturity also means interest rates are usually lower than for long-term debt.
In short, yes, commercial paper is a type of short-term debt security used by companies to meet temporary working capital needs. For investors, it provides a way to earn interest on idle cash over a short period.
Commercial Paper Terms
Commercial paper is a money market security issued by large corporations to raise funds to meet short-term financial needs. It has the following key features:
- Maturity: Commercial paper maturities can range from 1 to 270 days. The most common maturities are 30, 60 and 90 days.
- Discount: Commercial paper is issued at a discount and is redeemed at maturity for full face value. The difference between the discount price and face value represents the interest earned by the investor.
- Unsecured: Commercial paper is an unsecured promissory note, meaning there is no collateral backing the issue. The creditworthiness of the issuing corporation is very important.
- Yield: The annualized yield earned on commercial paper is calculated based on the discount and the number of days to maturity. The higher the discount and shorter the maturity, the higher the yield.
- Credit ratings: The major credit rating agencies (S&P, Moody’s, Fitch-IBCA) assign short-term credit ratings to commercial paper issues based on the financial strength of the issuer. Higher-rated (A1/P1/F1 or better) issuers can issue at lower discounts.
- Secondary market: There is an active secondary market for commercial paper, allowing investors to sell their holdings before maturity if needed. However, prices in the secondary market can fluctuate, impacting the yield earned.
Example: ABC Corp needs short-term funding for 60 days. It issues ₦10 million in commercial paper maturing in 60 days. The paper is sold at a 2% discount, meaning investors pay ₦9.8 million for the full ₦10 million face value. In 60 days, ABC Corp redeems the paper by repaying the ₦10 million. The investors earn ₦200,000 in interest on their ₦9.8 million investment, which works out to an annualized yield of 4.08%.
Features and Characteristics of Commercial Paper
Commercial paper is a popular short-term investment vehicle issued by large corporations to raise money. As an investor, these characteristics are appealing:
- Low Risk: Commercial paper is low risk since it’s backed by large, stable companies with solid credit. The companies have a vested interest in repaying on time to maintain a good credit rating.
- Highly Liquid: Commercial paper is very liquid, meaning it can easily be converted to cash at any time before maturity without penalty. You can sell it on the open market if needed.
- Competitive Returns: While low risk, commercial paper offers returns that often exceed government securities with similar maturities. The higher yield compensates you for the marginally higher risk.
- Short-Term: Commercial paper maturities range from 1 to 270 days, so your money is not tied up for long. This flexibility allows you to react quickly to changes in interest rates.
- Minimal Fees: There are typically no commissions or management fees associated with commercial paper since it is a direct investment. More of your money works for you.
- Convenient: Commercial paper can be purchased and redeemed easily through most major brokerages and banks. You can invest without hassle.
- Choice of Maturities: You can choose maturities that match your liquidity needs, from very short-term to almost 1 year. Pick what’s right for your situation.
- Low Minimums: Most commercial paper can be purchased in minimum denominations of ₦5,000,000 or ₦50,000,000 making it accessible for many individual investors. You don’t need deep pockets to participate.
Advantages and Benefits of Using Commercial Paper
These are some of Commercial Paper:
Flexibility
Commercial paper gives businesses flexibility in managing their short-term financing needs. They can tailor the maturity dates and amounts to match their precise cash flow requirements.
Low cost
Commercial paper is a lower-cost source of short-term funding for large corporations since the interest rates are usually lower than bank loans. The low costs allow companies to finance their temporary cash needs cheaply.
Simple to arrange
Commercial paper is relatively simple to arrange as it does not require extensive paperwork or collateral like bank loans. The issuance process is quick, allowing companies to get funding rapidly.
Wide range of maturities
Commercial paper maturities typically range from 1 to 270 days, allowing companies to choose maturities that match their funding needs. They can select shorter or longer maturities depending on how long they need the financing.
Highly liquid
Commercial paper is highly liquid, meaning investors can easily buy and sell the notes on the secondary market. This liquidity and flexibility make commercial paper attractive to many investors.
Unsecured
Commercial paper is an unsecured form of debt, meaning no collateral is required. Companies are not required to pledge any assets to back the note. However, only very creditworthy companies can issue commercial paper since there is no collateral.
Anonymity
Commercial paper issuance allows companies to raise short-term financing anonymously without publicly disclosing the details of their funding needs. This confidentiality can be appealing to some companies.
Disadvantages and Limitation of Commercial Paper
Commercial paper although useful, has some disadvantages:
Limited Market
The market for commercial paper is limited to large institutional investors and corporations. Small investors do not participate in this market.
Short Maturities
Commercial paper maturities are limited to 270 days. This exposes the issuers to rollover and interest rate risks. The issuers have to repay the principal amount on maturity and reissue new commercial paper.
Credit Risk
There is a credit risk for investors as the commercial paper is unsecured. If the issuer defaults, the investors may lose their investment. Investors rely on the credit rating of issuers to evaluate the credit risk.
Fluctuating Interest Rates
Interest rates on commercial paper keep on changing with changes in market rates. This exposes issuers to interest rate risk. The interest cost may go up at the time of rollover of commercial paper.
High Administrative Costs
Frequent issuance and rollover of commercial paper lead to high administrative costs for issuers. Issuers have to bear underwriting and selling costs on each issue.
Uncertainty
There is uncertainty about the success and pricing of each issue of commercial paper. Although rare, an issue may not be fully subscribed exposing issuers to liquidity risk.
Disclosure Requirements
Issuers of commercial paper have to comply with disclosure requirements of regulators like SEC. This leads to additional paperwork and costs for issuers. Lack of compliance may lead to penalties.
Commercial Paper vs. Other Short-Term Funding Options
Commercial paper is typically cheaper than other short-term funding options like credit cards or personal loans. The interest rate on commercial paper is lower than unsecured forms of debt. This is because commercial paper is a short-term corporate debt instrument, meaning it is backed by the creditworthiness of the issuing company.
Overview of Commercial Paper in Nigeria
In Nigeria, commercial paper refers to short-term, unsecured promissory notes issued by large corporations to raise money. It is a money market instrument that provides a source of short-term funding for large companies. The funds are raised directly from investors instead of a bank loan.
Companies will issue commercial paper with maturities ranging from a few days up to 270 days. Investors, like money market funds, pension funds or mutual funds, buy the commercial paper at a discounted price, earning interest as the note maturities. For companies, commercial paper is an alternative to bank lending and provides flexibility in funding operations.
The central bank of Nigeria regulates the issuance of commercial paper. Companies must meet strict criteria related to creditworthiness and size to issue commercial paper. The paper is very liquid, meaning investors can sell it before maturity, though at a potential loss. However, commercial paper is generally very low risk due to the strict eligibility criteria for issuers. According to the guideline on BA CP via the Central Bank Of Nigeria it states that “1 CP shall be issued at the primary market for a minimum value of N100 million and in multiples of N50 million, thereafter.”.
In summary, commercial paper provides companies a source of short-term funding through the direct sale of unsecured promissory notes to investors. For investors, it offers a low-risk, short-term interest-earning opportunity. When regulated properly, commercial paper benefits both issuers and investors in Nigeria’s money markets.
Examples of Commercial Paper Issuers and Investors in Nigeria
You have several options for investing in or issuing commercial paper in Nigeria.
- Banks: Major banks like First Bank, UBA, and GT Bank issue commercial paper to raise short-term funds from investors. They are low-risk, highly regulated, and offer attractive yields.
- Blue chip companies: Large, well-established companies like Dangote Group, BUA Group, and Nestle Nigeria issue commercial paper. They have stable cash flows and strong credit, so the risk of default is minimal.
- Pension funds: Pension fund administrators like Stanbic IBTC Pension Managers invest in commercial paper on behalf of their clients. Commercial paper offers higher yields than Treasury bills with slightly higher risk.
- Insurance companies: Insurance providers like AIICO Insurance and Leadway Assurance are major investors in commercial paper. They have significant funds to invest and commercial paper provides more attractive returns than government securities.
- Asset management companies: Investment managers like Chapel Hill Denham, Cordros Capital, and Meristem invest client funds in commercial paper. They seek the highest yields for the lowest risk to maximize returns.
- High net worth individuals: Wealthy individuals also invest in commercial paper directly or through their investment managers. Commercial paper provides higher returns than savings accounts with relatively low risk.
Types of Commercial Paper
Commercial paper comes in a variety of types to suit the needs of different issuers and investors. The two major types of Commercial paper are: Promissory Notes and Drafts
Promissory notes
Promissory notes are written promises to pay a specific amount of money on a particular date. They are issued by companies to raise short-term funds from investors in the money market. The company promises to pay the investor the face value amount of the note on the maturity date.
Drafts
A draft is a written order given by one person to another to pay a defined sum to a third party on a specific date, it involves three parties. They are used by companies to raise short-term funds from investors. The company issues a draft directing its customer (the account party) to pay the face value amount of the draft to the investor (the holder) on the maturity date. The account party accepts the draft and promises to pay the holder. Drafts are usually used in trade finance.
Other types of Commercial paper include: Certificates of deposit, Notes, Cheques, Secured and Unsecured Commercial Paper.
Who Are the Primary Buyers of Commercial Paper?
The main purchasers of commercial paper are large institutional investors like:
Mutual funds, money market funds, and pension funds. These entities buy huge amounts of commercial paper to generate returns for their investors and account holders.
Commercial banks are also major investors in commercial paper. They purchase commercial paper to earn interest and invest their excess reserves. Buying short-term commercial paper is a convenient and low-risk way for banks to invest excess funds for a short time period.
Insurance companies regularly buy commercial paper as a way to invest policy premiums to generate investment income. The short maturities and high credit quality of commercial paper match well with the liquidity needs and risk tolerances of insurance companies.
Corporations that have excess cash may invest in commercial paper as a way to generate interest income from the excess cash. The cash can be reinvested quickly if needed for operational purposes.
Foreign investors, especially central banks, are also buyers of US commercial paper. They see it as a very low-risk way to invest funds in US dollars and earn interest.
In summary, the biggest investors in commercial paper are large institutions like money market funds, mutual funds, pension funds, banks, insurance companies, and foreign central banks. They are attracted to the safety, liquidity, and short maturities of commercial paper.
How Do Individuals Invest in Commercial Paper?
To invest in commercial paper as an individual, you’ll need to go through a broker that deals in money market securities. Here are the basic steps:
- Find a brokerage firm that trades commercial paper. Major brokerages like Charles Schwab, TD Ameritrade and Fidelity offer commercial paper. Do some research on their fees and account minimums.
- Open an account with the brokerage to buy and sell commercial paper. You’ll need to provide some personal information to verify your identity. Fund the account so you have cash available to invest in commercial paper.
- Review available commercial paper offerings. Your broker will have details on rates, maturities and issuing companies. Choose paper from highly-rated companies with maturities that match your investment timeline.
- Place an order with your broker to buy the commercial paper. They will purchase the paper on your behalf and deposit it into your account.
- Hold the commercial paper until maturity or sell it on the secondary market. At maturity, you’ll receive the face value of the paper. If you sell early, you may receive more or less than face value depending on the current interest rate environment.
- At maturity, the funds from the commercial paper will be deposited into your brokerage account in cash. You can then invest in new commercial paper or withdraw your money.
Investing in commercial paper as an individual takes some research to understand the product and the process. But for savvy investors, commercial paper can be a way to diversify a portfolio and earn competitive short-term yields. The key is finding a brokerage that provides access and guidance to this money market security.
Commercial Paper vs. Bonds
Commercial paper refers to short term debt instruments issued by companies to meet temporary short term financing needs. Unlike bonds, commercial paper is unsecured and issues for a shorter duration, usually less than a year.
On the other hand, bonds are long term debt securities issued by companies or governments to raise capital from investors. Bonds have a fixed interest rate and maturity period. They are secured by the assets of the issuer. Investors are exposed to higher risk in commercial paper compared to bonds. However, commercial paper offers higher returns due to higher risk.
In short, the key differences between commercial paper and bonds are:
- Maturity: Short term vs long term
- Risk: Higher vs lower
- Returns: Higher vs lower
- Security: Unsecured vs secured
Commercial paper is ideal for companies looking to meet temporary cash needs. Bonds suit long term capital raising requirements. For investors, choice depends on risk appetite and investment horizon.
Commercial Paper Formula
Commercial paper is an unsecured, short-term debt instrument issued by corporations to raise money. The formula for calculating the yield on commercial paper is:
Yield = (Purchase Price/Face Value) x (360/Maturity in Days)
Where the discount is the difference between the face value, or par value, of the commercial paper and its purchase price. The maturity period refers to the number of days until the commercial paper matures and the issuer repays the face value.
For example, if an investor buys ₦97,000 of 90-day commercial paper with a face value of ₦100,000, the formula is:
Yield = (₦100,000 – ₦97,000)/₦100,000 x (360/90) = 6%
So the annualized yield for this commercial paper is 6%. The yield a buyer receives depends on the maturity period and prevailing interest rates. Shorter maturities, like 30 to 60 days, typically have lower yields, while longer maturities of 6 months may have higher yields.
Pricing
Formula for Pricing Commercial Paper:
Price = Face Value / [1+(Yield/100 * Maturity Period/360)]
Commercial Paper Example
Commercial paper is a short-term unsecured promissory note issued by firms to raise funds. For example, if Company XYZ needs short-term funds for 6 months, it can issue commercial paper for ₦50,000. Investors buy this commercial paper at a discount and earn interest. At maturity, Company XYZ pays the face value.
Another example is if Company ABC needs funds to finance its inventory. It can issue commercial papers for 3 months. Investors will buy this short-term debt investment and ABC can use the funds to finance its operations.
Let’s solve an example: Company PQR needs ₦200,000 for 2 months. It issues a 2-month commercial paper with a face value of ₦200,000. Investors buy this commercial paper at 5% discount. What is the price of commercial paper? What interest will investors earn?
- Face value = ₦200,000
- Discount rate = 5%
- Discount = Face value x Discount rate = ₦200,000 x 5% = ₦10,000
- Price of commercial paper = Face value – Discount = ₦200,000 – ₦10,000 = ₦190,000
- Interest earned = (Face value – Price)/Price x (365/Maturity days) = (₦200,000 – ₦190,000)/₦190,000 x (365/60)
= ₦10,000/₦190,000 x 6.08%
= 3.23%
So the price of commercial paper is ₦190,000 and interest earned by investors is 3.23% for 2 months.
Frequently Asked Questions about Commercial Paper
These are some of the most asked questions and answers about commercial paper.
Who can invest in commercial paper?
Commercial paper can be purchased by corporations, pension funds, money market funds, and wealthy individuals.
How is the interest rate determined?
The interest rate on commercial paper depends on the credit rating of the issuing company and current market rates. Higher-rated companies can issue at lower rates.
How safe is commercial paper?
Although commercial paper is riskier than government securities, it is generally very safe if issued by top-rated companies with solid credit. However, there is a chance of default.
What are the advantages of commercial paper?
It provides a flexible, low-cost source of short-term funding for issuers. For investors, it offers a very liquid investment with competitive yields.
Conclusion
So there you have it, the lowdown on commercial paper. It’s a short-term financing instrument that businesses use to meet their working capital needs and manage cash flow. The advantages are clear: flexibility, low interest rates, easy transferability. While not without risks, commercial paper offers companies an alternative to traditional bank loans. Evaluate if it aligns with your business goals and risk tolerance. If the shoe fits, tap into this market and put commercial paper to work optimizing your capital structure. The potential rewards make it worth considering if the timing and terms make sense for your organization.