Commercial paper – What is commercial paper?
Commercial paper, also commonly abbreviated to CP, is a short-term debt instrument that companies can issue to raise funds.
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Issuing commercial paper
Commercial paper may be issued by many different types of borrower. Borrowers may include for example, commercial, industrial, and bank holding companies.
Commercial paper is issued in one of two ways. It’s either sold directly by the issuer to the investor(s), (who are normally institutional investors, for example, insurance companies, corporations, pension funds or money-market funds), or it’s handled by an intermediary bank or securities dealer.
Although commercial paper is sometimes issued as an interest-bearing note, it normally trades at a discount to its par value. What this means is that investors will often purchase CP below par (i.e. for less than its face value) and then receive its face value at maturity. The difference between the purchase price and the face value of the note is the interest received on the investment.
As a short-term instrument, CP normally matures within 270 days. The debt is usually issued at a discounted rate and reflects the market rates at that time. Commercial paper also usually issued by companies that have a very high credit rating. Therefore, CP is a relatively low-risk investment.
Commercial paper and credit ratings
For a company to be able to issue commercial paper, it needs to have the highest credit rating. Investors purchase CP based on the credit ratings of the company. This is because the understanding is that the company will buy the paper back, with interest, by the maturity date. Only companies that have the highest credit ratings will be able to do this.
A company will only have access to the commercial paper market and have investors who are willing to buy its paper if its excellent credit rating is maintained. If the credit rating of the issuing company is downgraded the interest rate for its paper will increase and the company may no longer be able to issue commercial paper.
Refinancing using commercial paper
As already noted, commercial paper is typically issued with a maturity date within 270 days. This means that the company has to pay the money back they’ve borrowed within nine months. However, it’s common for companies who are financing themselves with CP to issue new commercial paper to raise the money needed to retire maturing debt. It’s possible for a company to continue to do this as long as its credit rating remains good.
Example of refinancing using commercial paper
Suppose that Company X has issued commercial paper worth £200 million and this CP is due to mature in 10 weeks. Company X may not want to use any of its cash to retire that maturing loan, so they instead start to prepare another round of commercial paper and begin to contact investors. The new commercial paper they issue may be for £250 million, therefore covering the £200 million that is due with interest, and allow them to raise additional cash.
Advantages of commercial paper
Commercial paper can be issued quickly and cheaply. It’s a fast way for a company to raise money, as it doesn’t require any registration or approvals, which is needed when a company issues new stock and bonds. Moreover, it doesn’t need any collateral to back up the issuance.
Even though commercial paper typically has slightly higher interest rates than lines of credit or short-term loans from banks, this higher interest rate is a price worth paying for the flexibility ease of access to the commercial paper market. Using CP means that companies don’t need to spend time negotiating short term loans from banks.
Disadvantages of commercial paper
Commercial paper is highly dependent on good credit ratings, and a company can only access the CP market for as long as it maintains its financial stability. If a company suffers from heavy losses and bad financial results, its credit rating may be lowered, meaning that the company can no longer access the CP market.
If the company can’t access this market, then it can’t issue new commercial paper to refinance its outstanding debt. When this happens, the company has to very quickly sell assets or take new back loans so that it has the money to retire its commercial paper when it’s due.