Commercial Paper: Definition, How it Works, Examples – Business Insider

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Commercial paper is a short-term, unsecured debt obligation typically issued by large banks and corporations. As an individual investor, you may have seen it listed as one of the holdings of a mutual fund you own.
The nature of commercial paper makes it most suitable for institutional investors and perhaps wealthy individuals to buy it directly. Smaller investors are most likely to have exposure to it through products such as money market funds.
Commercial paper is issued by large institutions to raise money to cover short-term financial needs. It pays fixed interest rates and has maturities ranging from as few as one to as many as 270 days.

Unlike longer-term debt instruments, the Securities and Exchange Commission (SEC) doesn’t require commercial paper securities to be registered. This has several advantages for businesses because it allows them to avoid the hassle and cost of securing business loans. 
“Companies that can’t meet their short to middle-term obligations, such as payroll, seek capital by offering commercial papers to intermediaries at a discount, who in turn pass them to banks and investors at an amount equal to the face value of the note,” says Owen Wilcox, financial expert and co-founder of online credit broker USInstallmentLoans.
Commercial paper is backed by the financial strength of the issuers. They are typically well-established organizations with high credit ratings and consistent, substantial revenue streams.

Typically, commercial paper is issued at a discount in denominations of at least $100,000. Since the terms range from one day to nearly nine months, commercial paper is a common funding mechanism large companies use for short-term, high-value financial obligations such as payroll, accounts payable, inventories, lease payments, and taxes. 
Before the global financial crisis of 2007-2008, the commercial paper market had reached an all-time high of just over $2 trillion, according to the Federal Reserve Bank of St. Louis. After gradually recovering through the years, the market dropped sharply again at the outset of the pandemic in 2020 to a little less than $1 trillion. As of late April 2022, there was about $1.1 trillion of commercial paper outstanding.
There are two main ways that commercial paper is issued. Issuers can sell securities to investors directly, or to a dealer. The main types of commercial paper are notes, drafts, checks, and certificates of deposit. 
Notes, or promissory notes, are written and notarized promises that one party will pay a specific amount to another party by a certain date. This is the most common way that organizations issue commercial paper.
While a note is an agreement between two parties (the payer and the payee), a draft is a written agreement between three parties. The bank is also involved in this type of commercial paper, and it instructs the issuer to pay a specific amount to the payee at a certain time. 
Checks are paid on-demand and are the fastest way to issue commercial paper. For this type of draft, the company tells the bank to give the payee a specific amount of money instantly. 
The final type of commercial paper is a certificate of deposit, which is a bank receipt that acknowledges a certain amount of money has been received and is to be paid back at a specific date. 
Issuers and investors consider commercial paper a highly liquid and low-risk asset. It’s a solid alternative to a traditional business loan for short-term obligations. So why don’t we hear about it more often in personal finance?
The minimum denomination of $100,000 makes commercial paper inaccessible to most individual investors. You won’t find commercial paper listed on your favorite trading app. Those individuals who can afford to buy commercial paper make their purchases through brokers who buys it on their behalf. 
The main buyers of commercial paper are mutual funds, banks, insurance companies, and pension funds. Others can access commercial paper by investing in funds that hold it.
There are many reasons why companies may seek out commercial paper instead of a business loan. Traditional financial advice leans toward eliminating debt instead of creating more.  
Let’s say, for example, a large retail organization has recently bought a logistics company for cash and intends to keep much of its original staff on board. The cost of the acquisition is likely to cause money to be a bit tight for a while after the deal is closed.
In such a situation, making payroll for a new acquisition on top of existing employees may be a challenge. Although a large retail organization needs millions of dollars in a matter of weeks, a loan can take too long to process. In this case, the organization decides to use commercial paper as a short-term solution while it recoups from the merger.
As with any investment, commercial paper comes with risks and challenges. Here are some the main risks involved with commercial paper:
Commercial paper is not secured like other investment types, so if a company defaults and can no longer pay, the investor has little recourse. Although unsecured, commercial paper default is very rare. It is only issued by highly rated organizations. 
Another risk of investing in commercial paper is that there is no Federal Deposit Insurance Corporation (FDIC) insurance to back up the funds. Individuals who invest in money market accounts instead of commercial paper directly will benefit from the issuing bank’s FDIC insurance. 
If you’re expecting large gains, don’t invest in commercial paper. It has low interest rates that are unlikely to keep up with inflation and doesn’t yield large returns. But its short-term nature offsets inflation risks, and it can be rolled over, adding to the likelihood of better returns. 


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