Information > Financial Terms > This page

Commercial Paper
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

All classes of short-term negotiable instruments (notes, bills, and acceptances) that arise out of commercial, as distinguished from speculative, investment, real estate, personal, or public transactions; short-term notes, bills of exchange, and acceptances arising out of industrial, agricultural, or commercial transactions, the essential qualities of which are short-term maturity (three to six months), automatic or self-liquidating nature, and non-speculativeness in origin and purpose of use.

To be eligible for discount at Federal Reserve banks, commercial, agricultural, and industrial paper must have the following characteristics (Regulation A of the Board of Governors of Federal Reserve System):

1.    It must be a negotiable note, draft, or bill of exchange bearing the endorsement of a member bank, which has been issued or drawn, or the proceeds of which have been used or are to be used in producing, purchasing, carrying, or marketing goods in one or more of the steps of the process of production, manufacture, or distribution; or in meeting current operating expenses of a commercial, agricultural, or industrial business; or for the purpose of carrying or trading in direct obligations of the United States (i.e., bonds, notes, Treasury bills, or certificates of indebtedness of the United States).  (The last purpose referred to is not in keeping with the traditional concept of "commercial" paper.)

2.    It must not be a note, draft, or bill of exchange, the proceeds of which have been used or are to be used for permanent or fixed investments of any kind, such as land, buildings, or machinery, or for any other fixed capital purpose.

3.    It must not be a note, draft, or bill of exchange, the proceeds of which have been used or are to be used for transactions of a purely speculative character, or issued or drawn for the purpose of carrying or trading in stocks, bonds, or other investment securities except direct obligations of the United States .

4.    It must have a maturity at the time of discount of not more than 90 days, exclusive of days of grace, except that agricultural paper as defined may have a maturity of not more than nine months, exclusive of days of grace.

In the narrower, technical sense, commercial paper consists of notes maEagle Tradersg in less than one year (usually four to six months) which are the direct obligations of issuing mercantile or industrial corporations or co-partnerships, and are sold through the medium of commercial paper dealers and brokers, principally to banks in the larger financial centres and, to a smaller extent, to insurance companies, savings banks, and business corporations.  In recent years, however, minimum denomination has become $10,000 generally, and round lost of $1 million are not uncommon.  Rates vary according to the credit standing of the issuer and money market conditions.  Moody's Investors Service and Standard & Poor's Corporation provide credit ratings for commercial paper borrowers to guide investors buying paper in the commercial paper market; the companies rated are those popular with investors in the money market.  Prime paper, of course, is easiest to place with investors.

Commercial paper borrowing may be for the purpose of buying or carrying stocks of merchandise to be quickly resold, and may be regarded as a convenient method of financing inventory requirements at the seasonal peak.  Four classes of commercial paper usually appear in the open market:  unsecured single name, which accounts for most of the total; two-name paper, including trade paper, i.e., promissory notes given in settlement for goods purchased and endorsed by the seller, and non-trade paper bearing endorsement; collateral notes, which represent a minor portion of the total offered; finance company paper.  Besides finance, companies in recent years industrial companies have become substantial borrowers in the market.  Federal agencies, such as the Export-Import Bank and the Federal National Mortgage Association, have also resorted to this market.

The advantages of issuing commercial paper from the standpoint of the borrower are fivefold.

1.    To obtain cash with which to take advantage of cash discounts offered by trade creditors.  Credit terms differ among various lines, but almost without exception cash discounts are offered where payment is made in advance of the term allowed for payment of invoices.  In the wholesale hardware field, for example, most frequently used terms are 2%/10 days, net 30 days to industrial buyers; and 2%/10 days, net 30 days, E.O.M. (end of month) to jobbers and retailers.  In some lines, an even better discount may be allowed for spot cash.  Thus discounts and anticipations might range from 12% to 36% or more per year on a rate basis.  Since commercial loans even on a 16.5% (1981) basis indicate an important saving on merchandise purchases, cash discounts should be taken, since the cost of failure to take them is high even when resort is had to borrowing for the purpose.

2.    To establish national credit.  Many enterprises which issue commercial paper are nationally known organizations that have created a national market for their products through interstate selling and advertising.  In such cases, the issuance of commercial paper is prima facie evidence of a national credit reputation.

3.    To keep a reserve of borrowing power at local banks.  Local banking connections may not be able to supply all of a firm's seasonal requirements on open lines of credit or, if able to do so, may not supply the credits at as favourable rates as might be secured through the open market issuance of commercial paper.  By issuing commercial paper, a concern may keep its credit lines at its banks in reserve, and meanwhile have recourse to the money market where its commercial paper may be sold at cheaper rates.  It is conventional, moreover, for unexhausted lines of credit to cover commercial paper borrowings.

4.    To borrow at cheaper rates than is possible at the firm's banks.

5.    To establish a broader market for the paper than is possible locally.  Commercial paper may be sold anywhere, the function of commercial paper houses and note brokers being to find the most advantageous markets for their paper.  Usual "spread" for dealers is 0.12%, but this may rise to 0.25% for smaller issues, or 0.375%.  The commercial paper is listed on offering sheets and sold by mail, telephone, and salespersons.

The advantages of commercial paper from the standpoint of buyers are fourfold.

1.    The paper is rated prime.  In addition to the buyer's own credit check, commercial paper dealers and brokers maintain extensive credit files and the paper that they place is subjected to credit examination.  Such middlemen could not long continue in business if commercial paper issuers from whom they purchase could not meet their maturities.  Commercial paper dealers and brokers, therefore, in recent decades have raised the standards of their paper through use of audited financial statements, credit investigation, and even influence over the borrowing and operating policies of borrowers, so that losses on commercial paper have been negligible even in years of depression.  Commercial paper purchases, therefore, are arranged only with concerns that have a firmly established earning power, open lines of credit to cover outstandings, adequate balances and financial condition, and other satisfactory banking relationships.  Insolvency of the Penn Central in June, 1970, with some $82 million in prime rated commercial paper unpaid, was a shock to the commercial paper market and severely affected volume.  Confidence gradually returned, however, as evaluation and rating procedures were tightened.  As of 1981, a virtual boom in commercial paper outstandings had developed.

2.    There is no moral obligation to renew commercial paper, i.e., insistence on payment at maturity and refusal to renew are no reflection on the commercial paper investor.  This differs from loans made to a bank's customers, where renewals might be necessary either as protection to the bank or as favour to a temporarily embarrassed borrower.

3.    Commercial paper furnishes a good investment medium, either for diversification of the "note pouch" of an investing bank to avoid overlarge proportion of local loans or for paper when the demand for credit over-the-counter has slackened.

4.    Commercial paper is attractive on a yield basis, in view of its quality, maturity, and liquidity.

The alleged disadvantage of commercial paper for the buyer is that usually it is single-name paper which does not evidence on its face the purpose for which the proceeds are used.  This disadvantage, however, is more apparent than real in view of the credit tests applied to the issuer.  Commercial paper is usually purchased on an option running from 10 to 20 days.  Within this period, the prospective purchaser retains the right to return any notes that he or she finds to be undesirable, the purpose of the option period being to give the buyer the opportunity to check the credit responsibility of the issuer.

Instead of commercial banks and corporations, as has been the case in past years, chief classes of investors in commercial paper are such nonblank investors as money market funds and other mutual funds, savings banks, insurance companies, private pension funds, and state and municipal retirement funds.

Non-financial company commercial paper is issued to meet the needs of public utilities and firms in manufacEagle Tradersg, construction, mining, wholesale and retail trade, and transportation and service industries.

BIBLIOGRAPHY

BANK FOR INTERNATIONAL SETTLEMENTS.  Recent Innovations in International Banking, Bank for International Settlements, Washington , DC , 1986.  
HURLEY, E "The Commercial Paper Market Since the Mid-Seventies."  Federal Reserve Bulletin, June, 1982.
SIGUM, M.  The Money Market.  Dow Jones-Irwin, Inc.,
Homewood , IL , 1983.  


Back to Information