“The commercial paper, when that dries up, you know, that’s just like sucking the blood out of the economic body of the United States.”
Commercial paper’s nature makes it worthy for institutional and wealthy investors to buy direct, while smaller investors get exposure via their money market funds or brokerage accounts.
Most corporations require short-term funding to meet day-to-day needs, and commercial paper helps fill the gap for things such as payroll or inventory.
Most retail investors remain unaware of commercial paper, its role, and how they might invest in the product, and today’s post will help shed some light on this unknown debt product.
In today’s post, we will learn:
- Commercial Paper Definition
- How Does Commercial Paper Work?
- What Are the Requirements for Commercial Paper?
- What Are the Four Types of Commercial Paper?
- Commercial Paper Markets
- Examples of Commercial Paper
- How Investors Can Buy Commercial Paper
- Risks with Commercial Paper
- Investor Takeaway
Okay, let’s dive in and learn more about commercial paper for beginners.
Commercial Paper Definition
We can define commercial paper as:
“A commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable, inventories, and other short-term liabilities.”
Maturities on commercial paper typically last less than one calendar year, usually between one day and 270 days.
The commercial paper also sells at a discount to face value, reflecting current market rates.
Strange enough, tools like commercial paper are not modern inventions; history tells us merchants used them as long ago as Hammurabi, around 1700 BC. They fell into disuse after the fall of the Roman Empire and experienced a revival during the Renaissance.
We can divide the fixed-income security world into two main camps:
- Capital markets consist of securities with maturities longer than 270 days.
- Money markets with securities maturing in less than 270 days.
These fixed incomes securities consist of a wide range of products, including:
The commercial paper’s largest use case remains corporations such as Amazon’s short-term cash needs, but this short-term investment can work for retail fixed-income investors who desire a better return rate.
For example, Cisco’s current balance sheet has cash and equivalents of $6,952 million, of which $548 million in commercial paper occupies.
How Does Commercial Paper Work?
Large corporations such as Cisco or Microsoft issue commercial paper to raise money to cover short-term financial needs such as payroll or inventories.
The commercial paper pays a fixed interest rate with maturities ranging between 1 and 270 days.
Unlike longer-term debt securities such as corporate bonds, the SEC (Securities and Exchange Commission) doesn’t require the registration of commercial paper securities.
The lack of registration benefits corporations in several ways:
- Avoid the hassle of applying for loans
- Reduces the cost of securing loans
“Companies that can’t meet their short to middle-term obligations, such as payroll, seek capital by offering commercial papers to intermediaries at a discount, who in turn pass them to banks and investors at an amount equal to the face value of the note,”
The commercial paper issuers’ strength stems from the company’s fiscal strength, such as Cisco or Microsoft. These companies often carry high credit ratings and consistent, large revenue streams.
Corporations issue commercial paper at face value discounts, often costing $100k. The commercial paper terms range from one day to 270 days, with the common terms 90 days or less. For example, Apple’s (AAPL) balance sheet carries $4,952 million in commercial paper with maturities of less than 90 days.
In their latest 10-k (4/8/22), Apple states they use commercial paper for “general corporate purposes, including dividends and share repurchases.”
What Are the Requirements for Commercial Paper?
Commercial paper, like other debt instruments such as bonds, have legal requirements that corporations must follow to issue the debt.
The following requirements are necessary for the commercial paper to be negotiable:
- A writing
- Signed by the issuer
- Contain an Unconditional Promise to Pay
- A Definitive Amount
- Payable on Demand or on Time, and
- Payable to Order or to Bearer
To avoid boring everyone with all the legalese, please check out this link for a more detailed look into each item necessary.
What Are the Four Types of Commercial Paper?
Commercial paper operates from four types:
- Certificates of Deposit (CD)
Issuers have two ways to sell commercial paper; they can sell directly to investors or dealers. They offer the four main types from corporations to bankers, who sell them to dealers or investors.
Drafts are a type of commercial paper written between three parties: drawer, drawee, and payer, with the bank involved in the transaction directing the issuer to pay a specific amount to the payee at a certain time.
Checks remain the fastest way to issue commercial paper, with checks considered a form of on-demand debt. For checks, corporations direct the bank to give the payee a specific amount, $1 million, for example, now.
Written and notarized promises known as promissory notes assure all parties that one party will pay a specific amount ($1 million, for example) to another party on a certain day. Promissory notes remain the most common form of issuing commercial paper for corporations.
4. Certificates of deposit (CD)
The final form of commercial paper constitutes a certificate of deposit. These bank receipts acknowledge a certain amount of money ($1 million) received and paid back by a certain date.
Commercial Paper Markets
Commercial paper traditionally issues and trades among companies in denominations of $100,000, with notes over this amount available in $1,000 tranches (installments).
Historically, some of the largest banks or financials, such as Goldman Sachs, Morgan Stanley, and JP Morgan, have been the largest buyers in the commercial paper markets. There exists a secondary market for commercial paper in the banking sector, as well.
In the past, wealthy investors could access commercial paper offerings through private placements. During 2008, the commercial paper market took a direct hit when Lehman Brothers declared bankruptcy.
In the aftermath of the Great Financial Crisis, new rules and restrictions on the type and amount of commercial paper available for holding inside money market mutual funds began.
Despite the new rulings, commercial paper became increasingly available to retail investors through online brokerages like Charles Schwab and Fidelity. For example, when you hold cash in your brokerage account before investing the money, the brokerage holds the cash inside a money market fund which most often contains commercial paper.
Investors like commercial paper because it often pays a better interest rate than other fixed-income investments. The rates also tend to rise with the US GDP, making them appealing to short-term investors.
Some banks also allow customers to write checks and make transfers online with commercial paper accounts like a checking or money market account.
Examples of Commercial Paper
A great example of a real-world use case would take Microsoft, which would like additional funding to launch new research and development projects around the cloud product, Azure.
Management would then weigh their options and decide that using commercial paper as a source of funding would offer a more attractive choice than traditional bond funding or taking out a line of credit.
In this situation, Microsoft would leverage its status as an established business with a strong credit rating (AAA) to issue the unsecured debt (commercial paper). Another bonus for Microsoft: this type of funding would also lower the company’s cost of capital.
Another example might include the retailer Home Depot. They might use commercial paper to fund some short-term investments in inventory for the holiday season.
Home Depot needs $10 million of cash, offering investors $10.1 million, including $0.1 million in interest payments, equating to a 1% interest payment.
Many companies carry commercial paper credit facilities to enable them to borrow whenever the need arises, including cash flow generating companies like Apple.
Most of them will use commercial paper as a cheaper source of capital for short-term needs such as inventory or payroll. But some companies use it as a source of cheap capital for investments such as R&D.
As with our finances, sometimes it makes sense to pay down more expensive debt using cheaper money to save the company in the long run.
The last advantage of using commercial paper instead of long-term debt is the time required to secure a longer-term loan which can take months to work out the details with a bank.
How Investors Can Invest in Commercial Paper
As we have discussed, commercial paper is a fixed-income investment used by large companies to meet short-term needs. When we invest in commercial paper, the investment pays us a fixed interest rate plus the note’s principal balance upon maturity.
Since commercial paper consists of short-term investments, maturing within 270 days, the fund comprises a mixture of CDs, U.S. Treasury bills, or promissory notes.
But, not everyone can invest in commercial paper. One of the biggest hurdles to becoming an investor equals the entrance fee, which hovers around $100,000 or more for each issue. Most commercial paper investors remain large corporations or banks.
Individuals can invest in commercial paper through a broker, but it takes substantial funds to invest because of the $100k increments. Other factors prohibiting investing in the commercial paper include:
- Regulatory costs
- The scale of investable capital needed to invest
- Physical access to capital markets
Another hindrance remains that broker-dealers issuing commercial papers on behalf of clients have pre-existing relationships with their institutional buyers, enabling market efficiency through large purchases of primary offerings. These broker-dealers would not likely look to individual investors as a source of capital for Microsoft, for example.
Retail investors can partake in commercial paper investments by buying commercial paper funds or money market funds that invest in commercial paper.
We should note that although commercial paper resembles a bond, it doesn’t operate similarly. The commercial paper doesn’t pay a regular interest payment like a bond; instead, investors make money on the difference in its face value (what we paid for it) and the difference at maturity, plus any agreed-upon interest rates.
Most of the benefits of investing in commercial paper lie with the issuer of the paper, mainly because it’s an easy way for a company to gain short-term financing.
Commercial paper offers many benefits:
- Cheaper than loans
- Doesn’t require any collateral
- Short-term loans
Another big benefit: commercial paper isn’t required to register with the SEC due to its short-term nature.
Risks with Commercial Paper
As with any investment, commercial paper comes with its own sets of risks and challenges.
Below are some of the main risks of investing in commercial paper.
The commercial paper offers little in securing the loans because of their short-term nature. So if a company defaults on the loan, investors have little recourse to recoup their investment.
Although commercial paper operates as unsecured debt, defaults remain rare because only highly-rated corporations offer commercial paper.
Currently, there remains zero FDIC (Federal Deposit Insurance Corporation) insurance to back up any funds. Individuals who invest in money market funds instead of commercial paper directly benefit from FDIC insurance.
Commercial paper remains solely backed by the financial strength of the companies issuing the paper. Standard & Poor’s and Moody’s commercial rate paper regularly use the same system to rate corporate bonds, with AAA and Aaa being their highest ratings, respectively.
As with corporate bonds, commercial paper with lower ratings tends to pay higher interest rates, but no junk bond market remains available, as only investment-grade companies issue commercial paper.
Low returns on investment
Because of its short-term nature, the commercial paper doesn’t offer large returns. But because of its short-term nature, it can offset inflation risks, and they offer the ability to roll over, which could add to better returns.
Commercial paper offers many advantages for institutions to generate capital for short-term needs, such as quick funding and the lack of regulatory controls.
But for individual investors, the better option to take advantage of this liquid, short-term investment is to seek out money market funds that invest in commercial paper.
With the current low-interest rates, many companies continue to look to commercial paper as a cheap means of funding projects or covering short-term expenses.
As investors, it helps us understand how companies, even as mighty as Apple, will turn to commercial paper to fund priorities from time to time.
And with that, we will wrap up our discussion today concerning commercial paper.
Thank you for taking the time to read today’s post. Please don’t hesitate to reach out if I can be of any further assistance.
Until next time, take care and be safe out there,