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.
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):
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"
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
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
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
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.
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.
advantages of issuing commercial paper from the standpoint of the borrower
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.
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.
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.
borrow at cheaper rates than is possible at the firm's banks.
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.
advantages of commercial paper from the standpoint of buyers are fourfold.
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.
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
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
paper is attractive on a yield basis, in view of its quality, maturity,
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
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.
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.
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.
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