Definition
The term commercial paper refers to an unsecured debt instrument issued by a corporation that matures in 270 days or less. Commercial paper is typically issued to finance short-term debt obligations such as payroll, or to finance short-term assets such as accounts receivable.
Explanation
Commercial paper is a security issued by corporations to fund recurring, short-term debt obligations. These are unsecured loans, which means they are only backed by the issuing corporation's promise to pay the face amount when the obligation matures. Since these loans are not secured by assets, only corporations with acceptable credit ratings are able to sell these securities at reasonable rates of interest.
Commercial paper is typically sold at a discount to face value, and will provide investors with an interest rate that is lower than debt obligations with longer maturities. Since commercial paper is issued by large corporations, it's typically sold in denominations of $100,000 or more. For this reason, buyers are usually large financial institutions and money market funds.
Some of the advantages of issuing commercial paper include:
Since commercial paper is an unsecured loan, it does not create a lien on the corporation's assets.
Corporations with good credit ratings can issue commercial paper at relatively low interest rates; thereby lowering their overall cost to borrow.
With maturities that range to 270 days, commercial paper provides corporations with an alternative to issuing a more administratively complex short-term bond offering.
There is a robust market for commercial paper, which provides investors an opportunity to enter and exit these offerings.
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