When businesses need to raise capital, one of the options they can exercise is commercial paper.
What Is Commercial Paper?
Commercial paper is a type of short-term debt instrument issued by corporations and financial institutions. It is used to raise funds for working capital, and other short-term needs, and is generally considered to be a low-risk investment.
Due to its short maturity and high credit quality, commercial paper is considered a safe and liquid investment option for businesses and investors alike.
In this article, we take a closer look at commercial paper, its types, its features, how it is issued, and regulated, as well as the pros and cons of investing in it.
Jump to a section:
- Commercial Paper: A Brief History
- How Does Commercial Paper Work?
- Features of Commercial Paper
- Forms of Commercial Paper
- Pros and Cons of Commercial Paper
- How To Invest In Commercial Papers In Nigeria
Commercial Paper: A Brief History
Commercial paper has been used as a source of short-term funding for businesses for over a century. The first was issued in the 1880s by large corporations. Initially, it was sold only to a select group of large investors, such as banks and insurance companies. But, as the market grew, it became more widely available to a wider range of investors. Today, commercial paper is a major source of short-term funding for businesses and is widely traded in the financial markets.
How Does Commercial Paper Work
Imagine that a big company, like an electronics store, needs some money to buy more electronics products to sell in their store. But they don’t want to borrow the money for a long time, they just need it for a little while.
So instead of going to a bank to borrow money, they can make something called “commercial paper.” It’s like a big check, but instead of being written by a person, it’s written by the electronics store.
They give the commercial paper to people who have money, like you, and say “we promise to give you your money back after a short amount of time, like say 3 months.”
The people who have money can decide if they want to give the electronics store the money by buying the commercial paper. And just like a check, the electronics store can use the money they get from the commercial paper to buy more electronics products for their store.
In Nigeria, the maturity of commercial paper is between a minimum of 15 days to 270 days maximum. The debt is usually issued at a discount that reflects market interest rates.
Features of Commercial Paper
Below are the 10 key features of commercial paper:
- Short-term maturity: Most commercial papers mature within 30 to 90 days with the maximum being 270 days.
- High credit quality: It is usually issued by financially stable companies with a strong credit rating.
- Unsecured debt: It is not backed by any collateral, so it is considered unsecured debt. Investors commit based on the company’s financial strength, and ability to generate income.
- Non-convertible: Commercial paper cannot be converted into equity in the issuing company.
- Low-interest rate: Interest rates on commercial paper can be lower than other short-term debt instruments.
- Low-cost: Issuing commercial paper is generally less expensive than issuing bonds or other types of debt securities.
- Negotiable: It can be bought and sold in the secondary market, making it a liquid investment. The issuer repays the buyer in the future using liquid cash and no other assets.
- Traded in the money market: Commercial paper is a short-term money market instrument. Money market is a sector of the financial market where financial instruments with high liquidity and short maturities are traded.
- Discounted: Commercial paper is issued at a discount from its face value, and the return to the investor is the difference between the face value and the buying price.
- Unregulated: It is not regulated by the government, however, the issuer’s creditworthiness is important.
Forms of Commercial Paper
Here are four forms commercial paper can take:
1. Promissory Notes
A promissory note is a legal document that is written by one party to another and makes a promise to pay that party a certain sum of money by a specific date. Businesses can issue commercial paper in the form of notes.
2. Drafts
A draft is a signed contract between three parties: a bank (the drawer), a payer (the drawee), and a payee. The bank gives the commercial paper issuer instructions to pay the loan (payee) a certain sum of money at a specific time.
3. Checks
A bank pays checks immediately rather than by a timeframe. They are the quickest method of issuing commercial paper. In this form of commercial paper, the issuing company directs a bank to transfer a certain sum of money to the payee immediately.
4. Certificates of Deposit (CD)
A certificate of deposit states that a certain amount of money has been deposited by an investor with the bank. It commits to paying this money back along with interest at a predetermined time. The maturity date and interest rate are also specified in the CD.
Pros and Cons of Commercial Paper
| # | Pros | Cons |
| 1 | Low-risk | Unsecured |
| 2 | Short-term maturity | Limited returns |
| 3 | High liquidity | Credit risk |
Pros of Commercial Paper
- Low-risk: It is typically issued by financially stable companies with a strong credit rating, making it a low-risk investment option.
- Short-term maturity: It typically has a maturity of less than 270 days, which can be an advantage for investors who want to invest for a short period of time.
- High liquidity: It can be bought and sold in the secondary market, making it a liquid investment option.
Cons of Commercial Paper
- Unsecured: It is not backed by any collateral, which can make it a high-risk investment than a security with collateral.
- Limited returns: The returns on commercial paper are generally lower than those on other investments, such as bonds or stocks.
- Credit risk: The creditworthiness of the issuer is important for commercial paper, as it is an unsecured debt, so if the issuing company experiences financial difficulties, the investors may not get their funds back.
How To Invest In Commercial Papers In Nigeria
To invest in commercial paper, you can make inquiries from your bank. Your account officer may help you. They will inform you of the types of commercial papers, with interest rates, tenure, and minimum subscription.
What is the Difference between Commercial Paper and Treasury Bill?
Commercial papers are unsecured, short-term debts issued by a corporation, often to finance short-term liabilities. Treasury bills (T-Bill) are short-term debts backed by the government with a maturity of under one year.
What is the Difference between Commercial Paper and CD (certificate of deposit)?
Commercial paper is issued by financially stable companies with a strong credit rating. CDs, on the other hand, are issued by banks.
What is the validity of commercial paper?
The maturity period varies from 15 days to 270 days. Like Treasury bills, commercial papers are issued at a discount and redeemed at face value.
Who can issue commercial paper?
Corporations, financial institutions, and municipalities.
Bottom Line
Commercial papers are an excellent way for companies to raise money in the short term. They are considered a low-risk investment option for businesses and investors due to their short maturity and high credit quality. However, it is important to note that commercial paper is largely unregulated and investors should conduct their own research before investing.
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