What it means
Commercial paper is a short-term IOU issued by a large and creditworthy company, usually for a few days up to about nine months. A paper dealer, often a bank's trading arm or a securities firm, finds buyers for it.
The company receives cash now and promises to repay the face value on a set date. The dealer's role is to match issuers who need money with investors who have spare cash, such as money market funds.
Because the paper is sold at a discount to its face value, the investor's return is the difference between the price paid and the amount repaid. Dealers earn their income through a small margin, usually a fraction of a per cent a year of the amount sold.
Their value to the issuer is speed and reach, because they know which investors are looking for short-term assets and can place a large amount in a day or two. A company can also sell paper directly to investors without a dealer.
This saves the fee, but only the largest issuers tend to have the investor relationships and volume to make that practical. The nuance for a finance team is that dealers are only as useful as the market.
In a crisis, investors can stop buying commercial paper, and even well-known issuers may struggle to roll over their borrowing. Regulators and rating agencies watch the paper market closely because it links companies, banks and money market funds.
A shock in one corner can spread quickly, as lenders pull back from all issuers at once. For this reason, many companies treat a backup bank line as a standard companion to any commercial paper programme.
In practice
Real-world examples.
Example
A large manufacturer needs $50,000,000 for two months to cover a seasonal build-up in inventory. It uses a paper dealer to sell commercial paper to money market funds. The cash arrives within days and costs less than a bank loan. The treasurer keeps a record of the quotes received so the choice can be justified later.
Example
A money market fund manager calls a dealer to ask what 30-day paper is available from highly rated issuers. The dealer offers three options at different yields. The manager buys one and keeps the fund's cash earning a return. The trade settles the same day, so the fund has little idle cash overnight.
Example
A utility company reviews its funding costs and compares using a dealer with selling paper directly. The direct route would save about $40,000 a year, but it would need an in-house team. The treasurer decides to stay with the dealer for now. Her analysis is filed for the next funding review.
Formula
Calculation
Dealer fee = face value x annual fee rate x days / 360
A dealer places $10,000,000 of 90-day commercial paper for a company and charges an annual fee rate of 0.10%. The fee is 10,000,000 x 0.0010 x 90 / 360. That is 10,000,000 x 0.0010 = $10,000 a year, and 10,000 x 90 / 360 = $2,500 for the 90 days.Case study
Seen in the real world.
Riverbend Industries is an illustrative, fictional manufacturer that borrowed through a commercial paper programme arranged by two paper dealers. It rolled over about $30,000,000 of paper every quarter at rates lower than its bank line.
When markets were disrupted by an unexpected shock, investors stopped buying new paper for two weeks. Riverbend's treasurer had to draw on a standby bank facility to repay maturing paper.
The illustrative lesson is that the dealer is a link in a chain, not a guarantee. The company had kept the backup line in place, and that decision protected it from a cash crisis. The treasurer also began to review the dealers' pricing every quarter against the money market rates quoted by other banks, so that the company could see whether the fees remained fair.
Watch out
Common mistakes.
- Assuming commercial paper is risk free, when the issuer can still fail to repay and the market can close to new borrowers.
- Forgetting that paper must be repaid or rolled over on a fixed date, which creates a refinancing risk.
- Thinking a dealer guarantees the paper, when the dealer only helps to sell it unless it explicitly agrees to underwrite.
Questions
People also ask.
Who can issue commercial paper?
Mostly large companies with strong credit ratings, because investors want a very low chance of default over a short period. Issuers with weaker credit ratings may find the market closed to them, or may have to pay noticeably higher yields.
How does a dealer make money?
It earns a small fee or spread on the amount sold, or it earns the difference between the price it pays and the price it sells at. The dealer's fee is usually modest, but on large amounts it can still amount to tens of thousands of dollars a year.
Why is commercial paper sold at a discount?
Because it pays no separate interest, the investor's return comes from buying below face value and being repaid in full.
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