What it means
A large company with predictable cash needs of a few hundred million dollars for a few months can borrow from a bank or go to the market directly. Commercial paper is the direct route: the company issues a promissory note, sells it to investors at a discount, and repays the face value at maturity.
The difference between the discount price and face value is the investor's interest. The market works through programmes.
An issuer establishes a commercial paper programme with a maximum size, obtains ratings from the agencies (the short-term ratings, such as A-1 or P-1 for the strongest issuers), appoints dealers or sells directly, and then issues as needed, typically rolling maturing paper into new paper continuously so that the programme provides a standing source of funds. Issuance is fast: a treasurer can raise $100 million in a morning.
Rates are set by the market and are typically a few basis points above the rate on government bills for top-rated issuers, well below bank lending margins. The condition for access is credit quality.
Investors in commercial paper, especially money market funds, are highly risk-averse and restricted by regulation to top-rated paper; a downgrade to the second tier sharply reduces demand and raises cost, and a further downgrade closes the market. Issuers therefore maintain committed bank facilities at least equal to their outstanding paper, so that if they cannot roll it over they can repay from the facility.
Rating agencies require this backup as a condition of the rating. The risk that the backup exists to cover is rollover risk.
An issuer with $500 million of paper maturing over the next month depends on selling $500 million of new paper to repay it. In normal conditions that is routine.
In a crisis of confidence, whether about the issuer or about the market as a whole, investors decline to buy, the issuer must draw its bank lines, and if the lines are insufficient or the banks are also in difficulty, the issuer faces default on unsecured short-term debt with no recourse. The market's seizure in 2008 required central bank intervention to prevent exactly that for many large companies.
Variants include asset-backed commercial paper, issued by conduits holding receivables, mortgages or other assets rather than by operating companies, and which proved far riskier than its ratings suggested; and euro-commercial paper, issued in international markets in various currencies. Some companies also issue longer-dated medium-term notes under similar programmes.
For a corporate treasurer, commercial paper is the cheapest short-term funding available to an issuer that qualifies, and it is used for working capital fluctuations, seasonal builds, bridging acquisitions until term financing is arranged, and general liquidity. Its accounting is simple: a short-term borrowing, with the discount recognised as interest over the paper's life.
For an investor, it is a slightly higher-yielding alternative to government bills, with credit risk that must be monitored daily.
In practice
Real-world examples.
Example
A retailer issues commercial paper each autumn to fund its holiday inventory build and repays it from January cash receipts.
Example
A money market fund holds a portfolio of 30- to 60-day paper from 40 top-rated issuers, monitoring each daily and selling on any rating action.
Example
A company bridging a $2 billion acquisition issues commercial paper for three months until its bond issue settles, at a fraction of the cost of a bridge loan.
Think of it
“Commercial paper is short-term corporate IOUs-quick borrowing for companies with good credit.
Formula
Calculation
Discount Yield = (Face value minus Price) / Face value x (360 / Days to maturity)
Price = Face value x [1 minus (Discount rate x Days / 360)]
Investment Yield (bond-equivalent) = (Face value minus Price) / Price x (365 / Days)
All-in cost to issuer = Discount yield + Dealer fees + Backup facility commitment fee + Rating agency fees, annualised over the programme
Worked example. A manufacturer rated A-1/P-1 issues $50,000,000 of 90-day commercial paper at a discount rate of 5.20%.
- Price = $50,000,000 x [1 minus (0.052 x 90 / 360)] = $50,000,000 x (1 minus 0.013) = $49,350,000
- The issuer receives $49,350,000 and repays $50,000,000 in 90 days; interest cost $650,000
- Investment yield to the buyer = $650,000 / $49,350,000 x 365 / 90 = 1.317% x 4.056 = 5.34%
All-in cost to the issuer, annualised on a $200,000,000 programme with an average of $150,000,000 outstanding:
- Discount cost at 5.20%: about $7,800,000 a year on $150,000,000
- Dealer fee 0.05%: $75,000
- Backup revolving credit facility of $200,000,000, commitment fee 0.20% on the undrawn amount: $400,000
- Rating agency and programme costs: $60,000
- Total about $8,335,000 on $150,000,000 = 5.56% all-in
Comparison: the same company's bank revolving facility, if drawn, costs a benchmark rate plus 1.00%, currently 6.30%: $9,450,000 on $150,000,000. Commercial paper saves about $1,100,000 a year. The saving is the reason large companies issue paper; the backup facility is the reason they can.
Stress: the company is downgraded to A-2/P-2 after a profit warning. Money market funds, limited in their holdings of second-tier paper, reduce their purchases; the company's paper reprices to 5.90% and it can place only $80,000,000. It draws $70,000,000 on the backup facility at 6.30% to repay maturing paper. All-in cost rises to about 6.1% blended, and the treasurer's report to the board notes that a further downgrade would close the market entirely and that the facility, currently $200,000,000, is adequate only if the company reduces its reliance on paper.Case study
Seen in the real world.
A large equipment leasing company funded its lease book with commercial paper: $3 billion outstanding, rolled continuously, backed by $2 billion of committed bank lines, on the reasoning that the market had never closed for a top-rated issuer. When the credit crisis arrived, money market funds stopped buying paper from any financial issuer regardless of rating. Within two weeks the company had $1.2 billion of maturities it could not roll, drew its bank lines in full, and was $1 billion short with more maturities the following week.
It was rescued by a central bank facility created for the purpose and by an emergency sale of part of its lease book at a loss. The post-crisis review found that the company's backup lines had been sized to cover a partial rollover failure, not a total one, and that its treasury had regarded the difference as too improbable to fund.
The company's new policy required backup facilities of 100% of outstanding paper plus a cash reserve, a maturity ladder with no more than 15% of paper maturing in any week, and term funding for at least half the lease book. The treasurer's successor described the old model as borrowing overnight to lend for five years and calling the difference a margin.
Watch out
Common mistakes.
- Relying on commercial paper for long-term needs. It is short-term funding that must be rolled continuously, and the market can close without warning.
- Sizing backup facilities for a partial rollover failure. Rating agencies and prudent treasurers require backup for the full amount outstanding.
- An investor treating commercial paper as riskless because it is short and highly rated. It is unsecured corporate debt; ratings change and markets seize.
Questions
People also ask.
Who can issue commercial paper?
In practice, large companies and financial institutions with top-tier short-term credit ratings and committed backup bank facilities. Smaller or lower-rated companies use bank facilities instead.
Why is commercial paper cheaper than bank borrowing?
Because it goes directly to investors without the bank's margin, and because the investors are seeking safe short-term assets and accept low yields for top-rated paper.
What happens if an issuer cannot roll its paper?
It must repay from cash or backup bank facilities. If those are insufficient, it defaults on unsecured debt, which is why backup facilities are a condition of issuance.
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