Introduction To Commercial Paper

So far, 2014 has not turned out to be the year for commercial paper.  We’re not even halfway through January and commercial paper issuance has seen the largest contraction in the last four years as money-market funds look to other investments perceived to be safer.  According to the Federal Reserve, the amount outstanding as of January 1st has dropped $55.1 billion to a seasonally adjusted total of $1.046 trillion.

Typically, money-market funds have been large holders of foreign bank commercial paper, but have instead chosen other investments such as repurchase agreements.  The agreements are backed by collateral, making them safer alternatives.

What is Commercial Paper

Commercial paper is a short-term, unsecured promissory note with a maturity of 270 days or less.  Corporations issue CP to meet short-term obligations such as payroll or rent.  As with other fixed income offerings such as bonds, the longer the maturity, the higher the interest will be; although, the rate will most often be lower than borrowing from a bank. Because the rates are more competitive that banks, CP is usually a wiser choice than a line of credit for companies with excellent credit ratings.

In the US, companies issues commercial paper as a continuous program that has already been established and approved.  This allow the CP to be issued whenever the funds are needed, which allows for great flexibility and eliminates the need to continuously file registration statements. The registration statements themselves are time consuming and account for a lot of man-hours.

Who Issues Commercial Paper

All types of organizations will issue CP, but historically, financial institutions have issued the vast majority.  At the end of 2007, financial institutions sold roughly 83% of all CP domestically. Companies must also carry a solid credit rating to be considered worthy of CP issuance for that fact that the debt is not backed by collateral, increasing the default risk.

How To Issue

In order for the company to get its commercial paper in the hands of investors, one of two methods can be chosen. First, the securities can be marketed directly to the money market fund. The CP can also sell to a dealer who will then sell the paper in the market. Because CP is issued by primarily by financial institutions, it makes more sense for them act as agent themselves, excluding the middle man all together.

Risks

While CP is considered an extremely safe investment, default does and has occurred before. One of the most recent and notable disasters was the collapse of Lehman Brothers in 2008. Lehman’s bankruptcy resulted in the involvement of the Federal Reserve – something we’re all aware of (think too big to fail). During the collapse, two money market funds broke the buck, whereby the value per share dropped below $1.00. Prior to this event, that had not been seen in 37 years. Had the two funds in question not been supported, many other collapses would have occurred, further deepening the effects of the financial crisis.

 

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