Commercial paper is the most prevalent form of security in the money market, issued at a discount, with a yield slightly higher than Treasury bills. The main issuers of commercial paper are finance companies and banks, but also include corporations with strong credit, and even foreign corporations and sovereign issuers. The main buyers of commercial paper are mutual funds, banks, insurance companies, and pension funds. Because commercial paper is usually sold in round lots of $100,000, very few retail investors buy paper.
Commercial paper are unsecured promissory notes for a specified amount to be paid at a specified date. They are issued at a discount, with minimum denominations of $100,000. Terms range from 1 to 270 days.
Finance companies sell 2/3 of the total commercial paper, and sell their issues directly to the public. But corporations that borrow less frequently sell their commercial paper—called industrial paper—to paper dealers, who then sell them at a markup to other investors. A round lot for a paper dealer is $250,000.
Purpose of Issuance
While creditworthy corporations can borrow from banks for the prime rate of interest, they may be able to borrow at a lower rate by selling commercial paper. Commercial paper is also sold to provide seasonal and working capital for corporations, to provide bridge financing until longer term securities are sold or until money is expected to be received, such as tax receipts, and to finance the purchase of other securities. CDOs and SIVs, for instance, use commercial paper to finance the purchase of mortgage-backed securities (MBS), profiting from the difference of receiving the higher yield of MBS securities, and paying the lower yield of commercial paper.
As an example of bridge financing, a corporation may project that interest rates will be lower in the future, but, for business reasons, may want to finance a project immediately. It can finance the project immediately by issuing commercial paper with a maturity that coincides with the projected lower interest rates. Then it can issue long-term bonds, and use the proceeds to pay for the redemption of the commercial paper.
Issuers can be divided into financial and nonfinancial companies, although most issuers are financial. There are 3 types of finance companies:
- captive finance companies,
- bank-related finance companies,
- independent finance companies.
Captive finance companies are subsidiaries of manufacturers, with the purpose of providing financing for the manufacturer. The largest seller of commercial paper—General Motors Acceptance Corporation (GMAC)—is also a captive finance company that provides financing for the customers of General Motors. Other vehicle manufacturers also have captive finance companies to promote the sale of their vehicles.
Bank holding companies generally use finance companies to cater to customers with weaker credit. Independent finance companies are not affiliated with any other company or bank—hence, the name.
Generally, only corporations with the highest credit rating can issue commercial paper. Some companies with weaker credit can get credit enhancements, so that they can issue commercial paper. Asset-backed commercial paper is backed by high quality collateral. Credit-supported commercial paper is often guaranteed by an organization with excellent credit, such as a bank. Often, a letter of credit is used for this purpose, which is referred to as LOC paper. The bank promises to pay the face value of the paper if the issuer doesn't. Though the bank generally charges a fee equal to ½ of 1% of the issue, it is still cheaper than obtaining a loan from the bank.
Other costs that the issuer must pay are agents' fees to a bank for doing the paperwork necessary to issue commercial paper, and thousands of dollars must be spent to have the issue rated by a credit rating organization, such as Standard and Poor's and Moody's.
Most commercial paper has a maturity of about 45 days, and most are less than 90 days, although some commercial paper has a maturity of up to 270 days. The terms of the commercial paper is determined by a number of factors. One factor is the market. Buyers of commercial paper generally buy the terms that they want to coincide with their need for money.
The 270-day limit is dictated by the need to register the security with the SEC if the maturity is longer. This greatly increases the expense and time to issue—hence, commercial paper will rarely have terms longer than this. If the issuer needs the money longer, it can usually rollover the issue by issuing new commercial paper to pay off the maturing paper, which is often done. However, when credit dries up, then the issuer may become financially stressed. One of the aggravating factors of the 2007 - 2009 credit crisis was the inability to roll over maturing debt.
There is also a 90-day barrier for the length of terms. When a bank borrows from the Federal Reserve Bank discount window, it must provide collateral. The Federal Reserve will only accept commercial paper as collateral if it has a term of 90 days or less. This increases the demand for commercial paper with terms of 90 days or less, and, therefore, lowers the interest rate that the issuer would otherwise have to pay for the same term.
Most commercial paper is sold in round lots of $100,000, although there is some paper available in $25,000 lots.
Commercial Paper Market
Most commercial paper is bought in the primary market. The primary market consists of directly placed and dealer-placed paper. Directly placed commercial paper is sold directly to the investor by the issuer without the services of a securities firm. Most issuers of direct paper are finance companies that sell a large amount of paper continually, and have salespeople to sell the paper to investors.
Dealer paper is issued using the services of a securities firm, usually an investment bank, but, increasingly, large commercial banks. Commercial banks were prohibited from underwriting commercial paper by the Glass-Steagall Act, but the Federal Reserve, in June 1987, allowed subsidiaries of bank holding companies to underwrite commercial paper, which has significantly reduced the costs of issuing dealer paper to the issuer.
Although commercial paper is the most prevalent money market instrument, the secondary market is very small, primarily because the terms of commercial paper are very short, and because buyers of commercial paper usually purchase paper with maturities that coincide with their need for money. Hence, most holders of commercial paper hold it till maturity. However, in many cases, if the holder of commercial paper needs the money sooner, the commercial paper can usually be sold back to the issuer of direct paper or to the dealer of dealer paper.
Commercial Paper Yields
Commercial paper is a discount instrument—the interest earned is the difference between the face value and the discounted purchase price. Yields are calculated using a banker's year of 360 days.
The yields on commercial paper are usually 10 to 20 basis points above Treasury bills of the same maturity, primarily because the interest earned from commercial paper, unlike T-bills, is not exempt from state and local taxes. Commercial paper also has lower liquidity than T-bills, where trading in the secondary market is more active and bid/ask spreads, narrower.
There is also some credit risk. The main credit risk stems from rollover risk, when the issuer may not be able to sell new paper to pay for maturing paper, either because the market has changed, or the credit rating of the issuer has been downgraded. The best example of this is the recent downgrades of CDOs and SIVs by the credit rating agencies. CDOs and SIVs made money from mortgaged-backed securities that were financed with commercial paper. Because the commercial paper has much shorter maturities than the mortgaged-backed securities, the maturing paper has to be continually rolled over. But because of the subprime mortgage debacle, the commercial paper market dried up, especially for the CDOs and SIVs.
To calculate the investment yield (aka bond equivalent yield, or BEY) of commercial paper so as to compare it to the rates of return of other investments:
calculate the interest rate for the period;
then multiply the rate by the number of periods in a year.
|Interest Rate Per Term||Number of Terms per Year|
|Bond Equivalent Yield||=||Face Value - Price Paid|
|×||Actual Number of Days in Year|
Term Length in Days