Money Market: Commercial Paper in Terms of Loan
Commercial paper is an unsecured, short-term personal loan used by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount, reflecting current market interest rates.
Maturities on commercial paper are usually no longer than nine months, with maturities of between one and two months being the average.
Commercial paper is considered a very safe investment. Typically, only companies with high credit ratings and credit-worthiness issue commercial paper. Over the past 40 years, there have only been a handful of cases where corporations have defaulted on their commercial paper repayment.
Commercial paper is usually issued in denominations of $100,000 or more. Therefore, smaller investors can only invest in commercial paper indirectly through money market funds.
Commercial paper is sold at a discount, with the difference between that price and the face value at maturity comprising the return to the investor.
Benefits of commercial paper
Commercial paper does not have to be registered with the SEC if the term to maturity is nine months or less. The average maturity is around 30 days, so the elimination of the need to comply with SEC rules brings down the compliance costs of issuing these instruments.
Maturities and the amount of commercial paper can be adjusted to fit the needs of the borrower.
The financial crises
During the financial crises of 2008, the Federal Reserve had to step in and create the Commercial Paper Funding Facility to provide liquidity for this critical component of the money market. This helped to ensure that major corporate borrowers could continue to tap this market to fund their short-term cash needs.
Defaults in commercial paper have been rare over the years, with an average default rate around 3%. Perhaps the most significant default was in 1970 when Penn Central declared bankruptcy and defaulted on all of its outstanding commercial paper. All holders of these securities lost their investment, driving the commercial paper market down about 10%.
