Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable and inventories, and meeting short-term liabilities. Maturities rarely range longer than 270 days. It is usually issued at a discount from face value and reflects prevailing market interest rates.
Commercial paper is not usually backed by any form of collateral, making it a form of unsecured debt. As a result, only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue. Because it is issued by large institutions, the denominations of the offerings are substantial, usually $100,000 or more. Other corporations, financial institutions, wealthy individuals and money market funds are usually buyers of such debt instruments.
Advantages / Disadvantages of Commercial Paper
A major benefit is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months, or 270 days, making it a very cost-effective means of financing. Although maturities can go as long as 270 days before coming under the purview of the SEC, maturities for commercial paper average about 30 days, rarely reaching that threshold. The proceeds from this type of financing can only be used on current assets, or inventories, and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.
– 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 provides investors with exit options.
– 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 During the Financial Crisis
The market played a big role in the financial crisis starting in 2007. As investors began to doubt the financial health and liquidity of firms such as Lehman Brothers, the commercial paper market froze and firms were no longer able to access easy and affordable funding. This meant that the affected funds had net asset values under $1, reflecting the diminishing value of their outstanding commercial paper issued by firms of suspect financial health.
Example of Commercial Paper
One example is when a retail firm is looking for short-term funding to finance some new inventory for an upcoming holiday season. The firm needs $10 million and it offers investors $10.1 million in face value of commercial paper in exchange for $10 million in cash, according to prevailing interest rates. In effect, there would be a $0.1 million interest payment upon maturity in exchange for the $10 million in cash, equating to an interest rate of 1%. This interest rate can be adjusted for time, contingent on the number of days the commercial paper is outstanding.
Line of Credit
Commercial paper is a lower-cost alternative to a line of credit 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, because under the capital regulatory regimes set out by the Basel Accords, banks must anticipate that such unused lines of credit will be drawn upon if a company gets into financial distress. They must therefore put aside equity capital to account for potential loan losses also on the currently unused part of lines of credit, and will usually charge a fee for the cost of this equity capital.
Defaults on high quality commercial paper are rare, and cause concern when they occur. Since commercial paper is unsecured, there is very little recourse for investors who hold defaulted paper, except for calling in any other obligations or selling any held stock of the company. In fact, a large default can actually scare the entire commercial paper market.
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