Commercial Paper: A Valuable Tool for Businesses

Article Summary

Commercial paper serves as a valuable financing tool for businesses, providing lower interest rates, enhanced liquidity, and access to diverse investors. However, it also carries risks, including credit risk and dependency on market conditions. When comparing commercial paper to bonds, considerations such as maturity periods, interest rates, and issuer requirements come into play. By understanding these aspects, businesses and investors can make informed decisions regarding commercial paper usage.

What is commercial paper?

Commercial paper refers to unsecured promissory notes issued by corporations and financial institutions. It is a short-term financing instrument that helps companies meet their immediate funding needs. Typically, commercial paper has a maturity period of less than 270 days, making it a popular choice for businesses looking to bridge short-term cash flow gaps.

Issuers of commercial paper are usually well-established corporations with strong credit ratings or financial institutions with solid financial standing. They utilize commercial paper to raise funds quickly and at a lower cost compared to other short-term borrowing options.

The main characteristics of commercial paper include:

  • Unsecured nature: Commercial paper is typically unsecured, which means it is not backed by specific collateral. Instead, the creditworthiness of the issuer determines the risk associated with the investment.
  • Discounted issuance: Commercial paper is issued at a discount to its face value, which means that investors purchase it at a price lower than the amount they will receive at maturity.
  • Negotiable instrument: Commercial paper is considered a negotiable instrument, meaning it can be bought and sold in the secondary market before its maturity date.
  • Fixed maturity date: Commercial paper has a specific maturity date, indicating when the issuer must repay the principal amount to the investors.

How does commercial paper work?

The issuance process of commercial paper involves several key steps:

  • Issuer identification: A company or financial institution identifies its short-term funding requirements and determines the amount of commercial paper it intends to issue.
  • Creditworthiness assessment: The issuer’s creditworthiness is evaluated by credit rating agencies, such as Standard & Poor’s, Moody’s, or Fitch Ratings. These agencies assign credit ratings based on the issuer’s financial health, repayment ability, and overall risk profile.
  • Engagement with financial institutions: The issuing entity establishes relationships with financial institutions acting as dealers. These dealers, often large banks or investment firms, assist in facilitating the commercial paper issuance process.
  • Negotiation of terms: The issuer and the dealer negotiate the terms of the commercial paper, including the amount to be issued, the maturity date, and the discount rate. These terms are determined based on market conditions and the issuer’s creditworthiness.
  • Distribution to investors: Once the commercial paper is issued, the dealer distributes it to investors, including institutional investors, money market funds, and individual investors. Investors purchase commercial paper based on their investment objectives and risk tolerance.
  • Secondary market trading: Commercial paper can be traded in the secondary market, providing liquidity to investors who may choose to sell their holdings before the maturity date. The price at which commercial paper trades in the secondary market depends on market conditions and changes in the issuer’s creditworthiness.
  • Repayment at maturity: On the maturity date specified in the commercial paper, the issuer repays the principal amount to the investors. Interest payments may also be made periodically throughout the commercial paper’s term.

Types of commercial paper

Commercial paper encompasses various types that cater to the diverse financing needs of businesses. Let’s explore some common types of commercial paper:

  • Promissory Notes: Promissory notes are the most basic form of commercial paper. They represent a written promise from the issuer to repay a specified amount to the holder on a predetermined maturity date. Promissory notes are unsecured and typically have shorter maturity periods, ranging from a few days to a few months.
  • Certificates of Deposit (CDs): CDs are a type of commercial paper issued by banks and other financial institutions. They offer investors a fixed interest rate and have specified maturity dates. CDs are generally considered to be low-risk investments due to the backing of the issuing financial institution.
  • Bankers’ Acceptances: Bankers’ acceptances are short-term instruments used to facilitate international trade transactions. They are issued by banks on behalf of importers or exporters, providing a guarantee of payment for goods or services. Bankers’ acceptances usually have a maturity period of less than six months.
  • Asset-backed Commercial Paper (ABCP): ABCP is a type of commercial paper that is backed by specific underlying assets, such as trade receivables, credit card receivables, or mortgages. These assets act as collateral, providing additional security to investors. ABCP is commonly used by financial institutions to raise funds and manage liquidity.
  • Negotiable Certificates of Deposit (NCDs): NCDs are similar to traditional certificates of deposit, but they can be bought and sold in the secondary market before their maturity date. This feature provides investors with greater liquidity compared to regular CDs.
  • Commercial Paper with Warrants: Some commercial paper issuances may include attached warrants, which give the holder the right to purchase additional shares of the issuing company’s stock at a predetermined price. This type of commercial paper can be appealing to investors seeking potential capital appreciation along with the fixed income from the instrument.

Advantages of commercial paper

Commercial paper offers several advantages as a financing tool for businesses:

  • Lower interest rates: One of the primary benefits of commercial paper is that it generally carries lower interest rates compared to other forms of short-term borrowing, such as bank loans or lines of credit. This allows businesses to reduce their financing costs and improve their profitability.
  • Enhanced liquidity and flexibility: By issuing commercial paper, companies gain access to a highly liquid market where these instruments can be easily bought and sold. This provides businesses with greater flexibility in managing their short-term funding needs. They can quickly raise capital when necessary or repay the commercial paper if they have excess cash on hand.
  • Access to a diverse investor base: Commercial paper attracts a wide range of investors, including institutional investors, money market funds, and individual investors. This diverse investor base provides businesses with a broader pool of potential funding sources. It also allows them to tap into different investor preferences and risk appetites, increasing the likelihood of successfully raising funds.
  • Short-term financing option: Commercial paper is designed for short-term funding requirements, typically with maturities of less than 270 days. This makes it ideal for businesses that need funds to cover working capital needs, bridge temporary cash flow gaps, or finance specific projects or initiatives with shorter timeframes.
  • Credit rating flexibility: Companies issuing commercial paper can benefit from the flexibility offered by credit ratings. As their creditworthiness improves over time, they may receive higher credit ratings, which can lead to lower borrowing costs. Additionally, businesses with well-established credit ratings may find it easier to attract investors and negotiate favorable terms.

Disadvantages of commercial paper

While commercial paper offers numerous advantages, it also comes with certain disadvantages and risks:

  • Higher credit risk: Commercial paper is an unsecured debt instrument, meaning it does not have specific collateral backing it. As a result, it carries higher credit risk compared to secured debt instruments, such as asset-backed commercial paper or bonds. Investors face the possibility of the issuing company defaulting on repayment, which can result in financial losses.
  • Dependency on market conditions: The issuance and pricing of commercial paper are influenced by prevailing market conditions, including interest rates, liquidity, and investor sentiment. Changes in these conditions can affect the availability and cost of commercial paper. For example, during periods of economic instability or credit market tightness, the cost of commercial paper may increase, making it less attractive for issuers.
  • Limited recourse options in case of default: In the event of default, commercial paper investors have limited recourse options to recover their investment. Unlike bonds, which often have stronger legal protections and potential claims on specific assets, commercial paper holders may face challenges in obtaining repayment or recouping their losses. This highlights the importance of conducting thorough credit analysis and carefully assessing the creditworthiness of the issuing company before investing in commercial paper.
  • Maturity restrictions: Commercial paper has a relatively short maturity period, typically less than 270 days. While this can be advantageous for businesses seeking short-term financing, it also means that companies relying heavily on commercial paper need to constantly roll over their debt. This exposes them to potential refinancing risks if market conditions change, making it more difficult or costly to issue new commercial paper to repay existing obligations.
  • Market fluctuations: The market for commercial paper can be subject to fluctuations, particularly during periods of financial market volatility. Factors such as changes in interest rates, credit market conditions, or investor confidence can impact the availability, cost, and demand for commercial paper. Businesses using commercial paper as a primary source of short-term funding must be mindful of these market dynamics and manage their funding strategies accordingly.

Commercial paper vs. bonds

While both commercial paper and bonds serve as financing options, they differ in various aspects:

  • Maturity periods: Commercial paper has shorter maturity periods, usually less than 270 days, while bonds have longer-term maturities ranging from several years to decades.
  • Interest rates: Commercial paper generally offers lower interest rates compared to bonds, primarily due to the shorter maturity periods and lower credit risk associated with highly-rated issuers.
  • Issuer requirements: Commercial paper is typically issued by corporations and financial institutions, while bonds are issued by a broader range of entities, including governments, municipalities, and corporations.

The choice between commercial paper and bonds depends on factors such as the issuer’s creditworthiness, the desired funding period, and the specific needs and risk tolerance of the issuer.

Risks and considerations

When engaging in commercial paper transactions, it’s important to be aware of the risks and considerations associated with this financial instrument. Understanding these factors can help investors and businesses make informed decisions. Here are some key risks and considerations related to commercial paper:

Credit risk

One of the primary risks associated with commercial paper is credit risk. As an unsecured debt instrument, commercial paper exposes investors to the potential default or delayed repayment by the issuing company. Investors need to thoroughly assess the creditworthiness of the issuing entity before investing in its commercial paper. Credit ratings provided by reputable credit rating agencies can offer valuable insights into the financial health and repayment capacity of the issuer.

Market conditions

The availability and cost of commercial paper can be influenced by prevailing market conditions. Factors such as interest rates, liquidity, and investor sentiment can impact the commercial paper market. Changes in market conditions can affect the attractiveness of commercial paper as an investment option, as well as the rates at which it is issued. Investors and businesses should stay informed about market trends and conditions to assess the potential impact on their commercial paper investments or issuances.

Credit ratings

Credit ratings play a crucial role in evaluating the creditworthiness of commercial paper issuers. Ratings assigned by credit rating agencies indicate the level of risk associated with investing in a particular issuer’s commercial paper. Investors should consider credit ratings as an essential factor when assessing the reliability and repayment capacity of an issuer. Higher-rated commercial paper generally carries lower credit risk but may offer lower yields compared to lower-rated counterparts.

Investor suitability

While commercial paper is open to individual investors, certain eligibility criteria or minimum investment requirements may apply. Investors should ensure they meet the necessary qualifications to participate in the commercial paper market. It is crucial to align the investment in commercial paper with one’s investment objectives, risk tolerance, and liquidity needs. Understanding the characteristics and risks associated with commercial paper helps investors determine whether it is a suitable investment option for their portfolio.

Liquidity considerations

Although commercial paper is generally considered a liquid investment, market conditions can impact its liquidity. In times of market stress or economic downturns, the availability of buyers for commercial paper may decline, potentially affecting the ease of selling the instrument before maturity. Investors should carefully consider their liquidity needs and ensure they have contingency plans in place, especially when investing in longer-term commercial paper.

Regulatory and legal considerations

Businesses issuing commercial paper must comply with applicable regulatory requirements, including those related to disclosure, documentation, and reporting. Investors should be aware of the legal framework governing commercial paper transactions to ensure their investments are adequately protected. Understanding the legal and regulatory landscape helps both issuers and investors navigate potential risks and obligations associated with commercial paper.


What is the typical maturity period for commercial paper?

Commercial paper typically has a maturity period of less than 270 days, making it a short-term financing instrument.

Are individual investors eligible to invest in commercial paper?

Yes, individual investors can invest in commercial paper through money market funds or brokerage accounts.

How does commercial paper differ from corporate bonds?

Commercial paper has shorter maturity periods and lower interest rates compared to corporate bonds. Commercial paper is typically issued by corporations, while bonds can be issued by various entities.

Can commercial paper be used by small businesses or startups?

While commercial paper is more commonly utilized by large corporations and financial institutions, small businesses and startups with strong credit ratings can also issue commercial paper.

What happens if a company fails to repay its commercial paper?

If a company fails to repay its commercial paper, investors may face losses. However, the extent of the losses depends on the specific circumstances and any available recourse options.

Key takeaways

  • Commercial paper serves as a valuable short-term financing instrument for businesses.
  • It offers lower interest rates compared to other short-term borrowing options.
  • Commercial paper provides enhanced liquidity and flexibility to meet short-term funding requirements.
  • Issuing commercial paper allows businesses to access a diverse investor base.
  • However, commercial paper carries risks, including credit risk and dependency on market conditions.
View Article Sources
  1. Commercial Paper Rates and Outstanding Summary – The Federal Reserve System
  2. Primer: Money Market Funds and the Commercial Paper Market – U.S. Securities and Exchange Commission
  3. Commercial Paper Funding Facility: Frequently Asked Questions – Federal Reserve Bank of New York
  4. Commercial paper markets: a survey – Bank for International Settlements