What is Commercial Paper?
Commercial paper (CP) is a short-term note issued by corporations to raise funds. CP is an IOU or a document that acknowledges debt owed and serves as a promise to pay back the amount owed within a specified period. Commercial paper issued directly by companies typically has no security or collateral. As a result, only companies with good credit ratings can issue CP.
Key Learning Points
- Commercial papers (CPs) are a form of very short term traded public debt used by corporations to meet their short-term funding needs. Corporate commercial paper is typically unsecuritized
- In recent years Asset Backed Commercial Paper (ABCP) has become popular, but ACBP is normally issued by financial institutions
- The majority of commercial paper is issued for a very short-term period – usually measured in days (sometimes the term is overnight)
- The funds raised through commercial paper by non-financial corporations are typically used for immediate needs where cash is needed to meet short term obligations such as working capital funding
- Unlike bonds, commercial paper does not offer regular interest or coupon payments. CPs are usually issued for less than their face value or ‘at a discount’. Investors receive the full face value upon maturity
- Corporations issuing commercial paper typically need to have a very high credit rating, and also be issuing regularly into the market. They are typically very large companies
Commercial Paper Explained
Commercial paper is a form of debt to the issuer meaning it is an amount of money borrowed on the condition that it is repaid at a later date. The agreement almost always includes interest payments too. The commercial paper market is often referred to as the ‘money market’.
Commercial paper is just one of many different types of debt products available to companies in need of financing. The products can be grouped into four categories depending on whether they are due to be repaid within or over twelve months at inception, and whether they are traded in the public securities markets or are created by a direct relationship between the borrower and lender.
Commercial paper discounts and yields are calculated using a specific yearly day count convention. In the United States the day count convention for interest calculations is usually 360 days in a year.
|Borrowing direct from banks/financial companies||Issuing securities into the financial markets|
|< 1 Year||Revolving credit facility
|> 1 Year||Term loans
|Investment grade bonds
High yield bonds
Commercial papers are one form of a debt instrument. Here are some of its features:
Short-term Debt Instrument
Commercial paper is an unsecured form of public debt raised by issuing securities into the financial markets. The vast majority of commercial paper are issued for a very short term maturities (often overnight). Most commercial paper is issued for maturities below 270 days which avoids a specific SEC registration greatly increasing the cost of the issue.
CPs are reported as a current liability in the borrower’s balance sheet. Normally companies will ‘roll over’ their commercial paper programs financing at least some of the commercial paper repaid with new commercial paper.
If a corporation issues commercial paper it often will have a revolving credit facility ‘back stop’ in the event it can’t refinance its commercial paper in the market.
Uses of Funds Raised through CPs
Companies use the funds raised through commercial paper for their short-term funding needs such as accounts payable, inventory, and for financing seasonal working capital needs. Financial institutions and banks are big issuers of commercial paper and using it to support short-term funding of financial assets.
Commercial Paper vs. Bonds
Unlike some bonds, commercial paper does not offer multiple interest payments to investors. Commercial paper is usually issued for less than their face value, known as issuing at a discount. Investors receive the full face value upon maturity. Also, commercial paper has short maturities, unlike bonds that usually have maturities of more than 1 year.
Finding Commercial Paper in the Financial Statements
Here is a snapshot from the 2018 annual report of Honeywell International. The company’s balance sheet includes commercial paper in the current liabilities section.
Honeywell International, Inc. – Annual report 2018
In the section on “Liquidity and Capital Resources”, the company has mentioned commercial paper as a source of liquidity. It uses its commercial paper program for general corporate purposes and for financing acquisitions. The company adds its ability to raise funds through commercial paper is affected by its credit ratings.
Example: Commercial Paper
Here is some information from the website of Deutsche Telekom AG. The company has mentioned commercial paper as one of its sources of debt financing.
Deutsche Telekom AG -Investor relations, information on debt financing
This example highlights another application of commercial paper. The company clearly mentions that it does not use CPs to meet its short-term liquidity needs. Instead, it uses CPs as a source of financing to reduce its interest costs as CPs are a cheaper source of funding compared to their existing credit lines. This makes sense as typically interest rates for CPs are lower than lending rates charged by banks.
Example: Calculating interest from the discount
Commercial paper is quoted using a discount yield, which just means the % discount the paper is issued at. Below is the calculation to calculate the discount yield assuming a 360 day count:
The face value is the amount repaid at maturity (after 90 days in this case). The issue price is the amount given to the issuer by the investor. The discount yield is calculated by taking the discount in $s and dividing by the face value and then grossing up to a 360-day period from 90 days. The 360-day convention is from the days when calculations were done on slide rules rather than computers.
Example: Converting between a discount yield and a yield comparable to a bond
Comparing the cost of commercial paper to bond financing requires us to convert the discount yield to a normal yield and often to a 365 day basis to make the cost comparable to other sources of financing.
The face value is the amount repaid at maturity (after 30 days in this case). The discount yield is calculated using the methodology in the prior example.
We can calculate the issue price by taking the discount yield and converting it to a 30 day basis and the multiplying by the face value to calculate the discount and then deduct that from the issue price.
Next we calculate the bond equivalent yield, on a 365 basis in this case, by taking the amount of the discount and dividing by the issue price, and then grossing that up to a 365 day year.