Commercial Paper

This is short-term, unsecured debt, issued by corporations to fund day-to-day activities. It’s normally effected by selling promissory notes at a discount. To “issue” commercial paper means to ask for a loan, basically.

Most buyers of commercial paper are banks and other financial institutions. So it’s not much different than a loan, except that it’s very short-term and unsecured, and so it doesn’t go through the normal loan-vetting process.

For example, a corporation might sell a promissory note for $995,000 that can be redeemed in 30 days for $1 million. The bank that buys this will make a $5,000 profit in that 30 days, which is an effective interest rate of 6%.

When the 30 days comes up, the corporation will often pay off that note with additional commercial paper, meaning it becomes a constant debt expense on their books. They just keep rolling it over.

Commercial paper is kind of the “glue” that holds the corporate world together. If not for the liquidity that commercial paper provides, corporations would have hold large cash reserves to make sure they always had enough cash to cover expenses. By using commercial paper, they can use their capital for other things, and use commercial paper to even out the “gaps.”

Commercial paper is unsecured and uninsured, meaning the only guarantee it will be paid is the reputation of the company who issues it, as determined by te major credit rating agencies. Company in good standing can issue it as lower effective interest; companies in poor standing have to pay more interest. As of this writing, the commercial paper rates for AA-rated companies is 4.75%.

Commercial paper is usually issues in 30-day time increments, in amount increments of $100,000.

“Commercial paper” as a phrase is just a general category of financial instruments. There are a lot of specific ways commercial paper actually happens. The most common is a promissory note (discussed above), but there are other methods – drafts, CDs, checks (effectively post-dated), etc.