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Commercial Paper

Chapter · December 2004

DOI: 10.1016/B978-075066261-1.50049-9

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 22 Commercial Paper
Strictly speaking commercial paper is a money market product, and this chapter could be placed within the section
on money markets. However CP is an important corporate finance instrument and it is worthwhile to review the
subject now, as part of our discussion on corporate debt markets.
Companies fund part of their medium- and long-term capital requirements in the debt capital markets, through
the issue of bonds. Short-term capital and working capital is usually sourced directly from banks, in the form of
bank loans. An alternative short-term funding instrument however is commercial paper (CP), which is available to
corporates that have a sufficiently strong credit rating. Commercial paper is a short-term unsecured promissory
note. The issuer of the note promises to pay its holder a specified amount on a specified maturity date. CP normally
has a zero coupon and trades at a discount to its face value. The discount represents interest to the investor in the
period to maturity. CP is typically issued in bearer form, although some issues are in registered form.
Outside of the United States CP markets were not introduced until the mid-1980s, and in 1986 the US market
accounted for over 90% of outstanding commercial paper globally.1 In the US however, the market was developed in
the late nineteenth century, and as early as 1922 there were 2200 issuers of CP with $700 million outstanding. In
1998 there was just under $1 trillion outstanding, as shown in Table 22.1. CP was first issued in the United Kingdom
in 1986, and subsequently in other European countries.

$bln 1985 1991 1992 1993 1994 1995 1996 1997 1998
Financial firms 213.9 414.7 395.5 398.1 399.3 430.7 486.6 590.8 765.8
Non-financial firms 87.2 147.9 133.4 147.6 155.7 164.6 188.3 184.6 200.9
All Issuers 301.1 562.6 528.9 545.7 555 595.3 674.9 775.4 966.7
Table 22.1: The US Commercial Paper Market. Source: Federal Reserve Bulletin.
Originally the CP market was restricted to borrowers with high credit rating, and although lower-rated borrow-
ers do now issue CP, sometimes by obtaining credit enhancements or setting up collateral arrangements, issuance in
the market is still dominated by highly-rated companies. The majority of issues are very short-term, from 30 to 90
days in maturity; it is extremely rare to observe paper with a maturity of more than 270 days or nine months. This is
because of regulatory requirements in the US,2 which states that debt instruments with a maturity of less than 270
days need not be registered. Companies therefore issue CP with a maturity lower than nine months and so avoid the
administration costs associated with registering issues with the SEC.

US CP Eurocommercial CP
Currency US dollar Any Euro currency
Maturity 1 – 270 days 2 – 365 days
Common maturity 30 – 50 days 30 – 90 days
Interest Zero coupon, issued at discount Usually zero-coupon, issued at discount
Quotation On a discount rate basis On a discount rate basis or yield basis
Settlement T+0 T+2
Registration Bearer form Bearer form
Negotiable Yes Yes
Table 22.2: Comparison of US CP and Eurocommercial CP.

1
OECD (1989).
2
This is the Securities Act of 1933. Registration is with the Securities and Exchange Commission.
414

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 Chapter 22: Commercial Paper 415

As with MTNs there are two major markets, the US dollar market with outstanding amount in 1998 just under
$1 trillion as noted above, and the Eurocommercial paper market with outstanding value of $290 billion at the end of
1998.3 Commercial paper markets are wholesale markets, and transactions are typically very large size. In the US
over a third of all CP is purchased by money market unit trusts, known as mutual funds; other investors include
pension fund managers, retail or commercial banks, local authorities and corporate treasurers.
Although there is a secondary market in CP, very little trading activity takes place since investors generally hold
CP until maturity. This is to be expected because investors purchase CP that match their specific maturity
requirement. When an investor does wish to sell paper, it can be sold back to the dealer or, where the issuer has
placed the paper directly in the market (and not via an investment bank), it can be sold back to the issuer.

22.1 Commercial Paper programmes

The issuers of CP are often divided into two categories of company, banking and financial institutions and non-
financial companies. The majority of CP issues are by financial companies, as noted in Table 22.1. Financial
companies include not only banks but the financing arms of corporates such as General Motors, Ford Motor Credit
and Chrysler Financial. Most of the issuers have strong credit ratings, but lower-rated borrowers have tapped the
market, often after arranging credit support from a higher-rated company, such as a letter of credit from a bank, or
by arranging collateral for the issue in the form of high-quality assets such as Treasury bonds. CP issued with credit
support is known as credit-supported commercial paper, while paper backed with assets is known naturally enough,
as asset-backed commercial paper. Paper that is backed by a bank letter of credit is termed LOC paper. Although
banks charge a fee for issuing letters of credit, borrowers are often happy to arrange for this, since by so doing they
are able to tap the CP market. The yield paid on an issue of CP will be lower than a commercial bank loan.
Although CP is a short-dated security, typically of three- to six-month maturity, it is issued within a longer term
programme, usually for three to five years for euro paper; US CP programmes are often open-ended. For example a
company might arrange a five-year CP programme with a limit of $100 million. Once the programme is established
the company can issue CP up to this amount, say for maturities of 30 or 60 days. The programme is continuous and
new CP can be issue at any time, daily if required. The total amount in issue cannot exceed the limit set for the
programme. A CP programme can be used by a company to manage its short-term liquidity, that is its working
capital requirements. New paper can be issued whenever a need for cash arises, and for an appropriate maturity.
Issuers often roll over their funding and use funds from a new issue of CP to redeem a maturing issue. There is a
risk that an issuer might be unable to roll over the paper where there is a lack of investor interest in the new issue. To
provide protection against this risk issuers often arrange a stand-by line of credit from a bank, normally for all of the
CP programme, to draw against in the event that it cannot place a new issue.
There are two methods by which CP is issued, known as direct-issued or direct paper and dealer-issued or dealer
paper. Direct paper is sold by the issuing firm directly to investors, and no agent bank or securities house is
involved. It is common for financial companies to issue CP directly to their customers, often because they have
continuous programmes and constantly roll-over their paper. It is therefore cost-effective for them to have their own
sales arm and sell their CP direct. The treasury arms of certain non-financial companies also issue direct paper; this
includes for example British Airways plc corporate treasury, which runs a continuous direct CP programme, used to
provide short-term working capital for the company. Dealer paper is paper that is sold using a banking or securities
house intermediary. In the US, dealer CP is effectively dominated by investment banks, as retail (commercial) banks
were until recently forbidden from underwriting commercial paper. This restriction has since been removed and
now both investment banks and commercial paper underwrite dealer paper.
Although CP is issued within a programme, like MTNs, there are of course key differences between the two types
of paper, reflecting CP’s status as a money market instrument. The CP market is issuer-driven, with daily offerings
to the market. MTNs in contrast are more investor-driven; issuers will offer them when demand appears. In this
respect MTNs issues are often “opportunistic”, taking advantage of favourable conditions in the market.

3
Source: BIS.

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 416 Part III: Corporate Debt Markets

22.2 Commercial paper yields

Commercial paper is a discount instrument. There have been issues of coupon CP, but this very unusual. Thus CP is
sold at a discount to its maturity value, and the difference between this maturity value and the purchase price is the
interest earned by the investor. The CP day-count base is 360 days in the US and euro markets, and 365 days in the
UK. The paper is quoted on a discount yield basis, in the same manner as Treasury bills. The yield on CP follows that
of other money market instruments and is a function of the short-dated yield curve. The yield on CP is higher than
the T-Bill rate; this is due to the credit risk that the investor is exposed to when holding CP, for tax reasons (in
certain jurisdictions interest earned on T-Bills is exempt from income tax) and because of the lower level of liquidity
available in the CP market. CP also pays a higher yield than Certificates of Deposit (CD), due to the lower liquidity of
the CP market.
Although CP is a discount instrument and trades as such in the US and UK, euro currency Eurocommercial
paper trades on a yield basis, similar to a CD. The discount rate for an instrument was discussed in Chapter 2. The
expressions below are a reminder of the relationship between true yield and discount rate.

P = M (22.1)
days
1+r×
year

rd = r (22.2)
days
1+r×
year

r = rd (22.3)
days
1 − rd ×
year
where M is the face value of the instrument, rd is the discount rate and r the true yield.
EXAMPLE 22.1
1. A 60-day CP note has a nominal value of $100,000. It is issued at a discount of 7½ per cent per annum. The
discount is calculated as:
$100 , 000 (0.075 × 60)
Dis =
360
= $1,250.
The issue price for the CP is therefore $100,000 − $1,250, or $98,750.
The money market yield on this note at the time of issue is:

(360360− (×0.0750.075x 60)) × 100% = 7.59%.

Another way to calculate this yield is to measure the capital gain (the discount) as a percentage of the CP’s
cost, and convert this from a 60-day yield to a one-year (360-day) yield, as shown below.
1, 250
r = × 360 × 100%
98 , 750 60
= 7.59%.
Note that these are US dollar CP and therefore have a 360-day base.
2. ABC plc wishes to issue CP with 90 days to maturity. The investment bank managing the issue advises that the
discount rate should be 9.5 per cent. What should the issue price be, and what is the money market yield for
investors?

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 Chapter 22: Commercial Paper 417

100 (0.095 × 90)

Dis =
360
= 2.375.
The issue price will be 97.625.
The yield to investors will be:
2.375 × 360 × 100% = 9.73%.
97.625 90

Selected bibliography
Alworth, J., Borio, C., “Commercial Paper Markets: A Survey”, BIS Economic Papers No.37, 1993, Bank for Inter-
national Settlements.
Corporate Finance, A Guide to Commercial Paper in Europe 1991, Euromoney Publications, September 1991.
Corporate Finance, Guide to International Commercial Paper, Euromoney Publications, January 1993.
OECD, Competition in Banking, OECD 1989.
Stigum, M., The Money Market, Dow-Jones Irwin, 1990.

Questions and exercises

1. Why is commercial paper an alternative to short-term bank borrowing for a corporation?
2. What is the difference between directly-placed paper and dealer-placed paper?
3. A money market fund purchases euro Eurocommercial with the following terms:
Purchase date 6 January 2000
Maturity date 6 April 2000
Yield 4.91%
Nominal amount €100 million
What cash amount is paid for the paper?
4. If you wish to achieve a yield of 6.25% on £10 million 30-day CP, what would be the discount rate and the
amount of the discount?
5. If the discount rate in the previous question was in fact 6.25%, what would the yield and the amount be?
6. What does the yield spread between commercial paper and equivalent maturity Treasury bills reflect?
7. A 180-day US dollar CP is purchased at a discount rate of 5.75%, and sold at a discount rate of 5.62% after 30
days. What yield has been achieved on an annualised basis?

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