Understanding what commercial paper means exploring how they work, what types there are, how they compare to bonds, and what advantages and disadvantages they provide investors.
What Is Commercial Paper?
Commercial paper is a short-term debt security that corporations use to raise capital. Because of their short maturity schedules, companies often use commercial paper to cover immediate expenses such as payroll and inventory. Commercial paper has a maturity of up to 270 days, but the average is about 30 days. The issuers of this type of debt security are most often financial institutions and large corporations.
How Does Commercial Paper Work?
Commercial paper is usually issued in two possible ways. First, the issuer might sell the debt securities directly to investors. They also might sell them to a dealer, who then turns around and sells them. Companies issue their commercial paper at a discount, meaning you pay less than the face value of the security. Companies typically write commercial paper in minimum denominations of $100,000 with terms ranging from one to 270 days, though the average maturity on commercial paper is around 30 days. The high minimum denominations make them inaccessible for most individual investors but debt investment tools like money-market funds make them more accessible. Commercial paper pays a fixed interest rate to investors. Like other interest-based investments, the rates tend to fluctuate with the market. In February 2021, the average monthly rate on a 90-day non-financial commercial paper loan fell to just 0.08%. This rate is down from an average of 1.44% in March 2020. Though commercial paper is unsecured, the default risk is relatively low. The issuers are generally creditworthy and well-established, and, in many cases, the paper has a rating from credit rating agencies. Standard & Poor’s, for example, issues credit ratings for commercial paper ranging from AAA (highest) to D (lowest).
Types of Commercial Paper
Notes
A promissory note, sometimes referred to as simply a “note,” is a written promise from one party to another to give them a specific amount of money at a predetermined time. There are only two parties to a promissory note: the payer (company) and payee (you).
Drafts
A draft is a written agreement with three parties: the drawer (usually the bank), the drawee (the company), and the payee (you). In this type of transaction, the drawer orders the drawee to pay a specific amount of money to the payee.
Checks
A check is a specific type of draft where one of the parties (the drawee) is the bank. With this type of transaction, the drawer (company) instructs the drawee to give a sum of money to the payee (you).
Certificates of Deposit
A certificate of deposit (CD) is a bank receipt where the financial institution acknowledges it has received a sum of money, and it agrees to pay it back at a specific time in the future. The certificate holds important information such as the interest rate on the commercial paper and the maturity date.
Commercial Paper vs. Bonds
Commercial paper and bonds are similar in many ways. Both are unsecured debt securities that companies can issue to raise capital but the two also have some notable differences. The Securities and Exchange Commission recommends that investors practice diversification to help reduce the risk of their portfolio. Because commercial paper has a low default risk, it may do the trick. Other investments such as long-term bonds and even high-yield savings accounts are likely to offer a higher return, especially when rates are low.
How Can Individual Investors Buy Commercial Paper
Commercial paper isn’t as accessible to individual investors as other opportunities might be. That doesn’t mean you can’t invest in them—it just means the path might look a bit different. Commercial paper is often sold directly to institutional investors like money market funds. Individual investors can include commercial paper in their portfolios by investing in money market funds. Even if companies sold commercial paper directly to individual investors, the $100,000 minimum would likely be too high for the average person. However, high net-worth individuals can purchase commercial paper through a broker who would buy them on your behalf.
