There is a variety of means companies can utilize in order to generate capital. Companies employ certain means rather than others depending on what specific needs they have to fulfill. Commercial paper is an unsecured promissory note which is typically used to fund short-term company projects. Since commercial paper is unsecured – meaning that it is not backed by collateral – it can only be issued by companies which have impeccable (or near impeccable) credit history. In this article we will discuss some of the basic facts of commercial paper and highlight how it is distinguished from other types of financial instruments.
Short-Term Debt Security
One of the main qualities which sets commercial paper apart from other types of debt securities is its short-term nature. Most commercial paper matures after 45 days, and the vast majority has a maturity date lasting no longer than 90 days. As a fixed rule, commercial paper cannot have a maturity date which lasts longer than 270 days because after 270 days the security would need to be registered with the SEC.
Because of its short-term nature, commercial paper generally has lower interest repayment rates when compared with long-term bonds.
In some ways, commercial paper can be viewed as a cost-effective alternative to lines of credit issued by banks. Commercial paper usually has lower interest rates and, being unsecured, also does not create a lien against the company. Of course, commercial paper cannot supplant lines of credit because the stellar credit ratings required to issue commercial paper necessarily limit its availability in the market.
Investors can either purchase commercial paper directly from the issuing company or from a third-party dealer. The third-party dealer is typically an investment bank, although commercial banks are increasingly taking part in the commercial paper market as third-party dealers. Commercial paper is typically sold in round lots of $100,000 and $250,000, although some commercial paper is available in lots of $25,000.
As of October of 2008, there was approximately $1.78 trillion in outstanding commercial paper in the United States. Commercial paper is issued frequently outside of the United States as well. The European market currently has about $500 million in outstanding commercial paper.
Though it is not something a small business owner will encounter on a regular basis, it is important for every businessperson to be familiar with commercial paper since it plays such a large role in the world of corporate finance.
Image credit: Tom Magliery
As this blog article shows, commercial paper is an important instrument for many companies. If you’re thinking of starting a company, be sure to view our presentation about the basic information all aspiring entrepreneurs should be aware of