What is Commercial Paper?
A corporation may issue bonds or equity to fulfill their long term capital needs; however, corporations are also in need of short term funds as well. As an alternative to bank borrowing, corporations may issue commercial paper which are basically short term, unsecured notes issued in the open market for immediate financing needs. The majority of commercial paper issuances are done through large corporations with solid credit ratings; however, in more recent history we have seen corporations with lower credit worthiness entering the marketplace. These corporations with sub-par credit quality will obtain credit support from a firm with a higher credit rating than themselves. This support is usually in the form of a "letter of credit" which is a guarantee by the supporting corporation that the debt will be repaid if the issuer defaults. The bank charges the issuer a fee for this and in turn the issuer has access to capital markets it otherwise wouldn't have access to. This type of commercial paper is also known as "LOC paper".
Commercial paper was originally issued to provide corporations with working capital in the short run but it is now being used for more longer term needs as well. This is called "bridge financing"; corporations may not find the current financial landscape the most ideal for issuing debt. Commercial paper allows a corporation to issue for the short run until longer term financing is opportune.
Why Issue Commercial Paper?
Stocks and bonds are subject to strict SEC requirements and registration. This takes time and money which commercial paper helps sidestep. The SEC regulation states that commercial paper with a term to maturity of less than 270 days is exempt from registration requirements. This is why commercial paper is rarely issued past 270 days. When the paper matures and an investor is due their investment plus principal back; corporations will "roll" the debt by issuing more commercial paper and using the proceeds to pay of maturing debt.
Commercial paper is typically sold in lots of $100,000 and sometimes in lots of $25,000. This is why most of the investment in this sector is from institutions, banks, and other large agencies. Most commercial paper is sold through financial companies such as automobile manufacturers; this is done through "captive financing". In our example with the automakers; General Motors uses GMAC (General Motors Acceptance Corporation) to provide loans for GM's customers.
Direct Paper Vs. Dealer Paper
Similar to the concept of the treasury bond auction, commercial paper can be issued, by corporations, directly to the public or through an intermediary broker. Direct paper is a cost effective means for already cash strapped corporations to borrow. They avoid the fees that are imposed by brokerage houses. Even though issuing directly to the public is a more cost effective method, brokerage firms still dominate the market for distribution. They have all the channels to investors and can get the job done quickly and efficiently. While direct paper is starting to gain more traction, it will be very difficult to cut the middle man out.
Commercial Paper Yields
Commercial paper is typically a discount instrument, like the zero coupon bond, and sold at a deep discount to par, or its maturity value. The spread between the purchase price and the maturity value is the interest payment. Yields are typically higher than their treasury equivalent for the obvious reasons; they have credit risk associated, they are taxable at the state level (while treasuries are not), and they are not as liquid of an investment as treasuries.
In conclusion, commercial paper is a good short term financing solution for corporations when market conditions do not warrant the issuance of longer term debt.