Tuesday, January 5, 2010

What is a commercial paper?

The commercial paper is a form of debt securities that is issued by companies. As we have seen in this post on bonds government and corporations issue bonds that have maturities of greater than one year on the capital market. With regards to maturities shorter than one year the government will issue treasury bills whereas corporations will issue commercial papers. The commercial paper will thus be, like the treasury bill, a money market instrument.

Hence the commercial paper will be issued at a discount by companies and at maturity the holder of the commercial paper will be paid the face value of the commercial paper. The discount rate will depend on the credit rating of the company and present market conditions. Since it is only companies with good credit rating that can issue commercial papers, the discount rate will slightly higher than government for treasury bills.

Companies are constantly in need of funds to settle current liabilities and to buy inventories. This is because there is always a mismatch between income and spending, The companies will thus raise the short term fund needed in the money market because use of banks for such short-term financing is costlier and time consuming.

Just like the treasury bills, commercial papers are quite safe. This is because the short-term maturities at which they are issued means that investors can determine whether the firm has a risk of default on the commercial paper. This is because investors would have known from previous financial statements whether the companies is sound and what is the possibility of it going bankrupt. However as you may know banks with their exposure to risky derivatives or bank runs may go bankrupt even if they were sound a few months or weeks before.However given the slight possibility of going bankrupt the return will be slightly higher than on treasury bills.

You might thus think that commercial papers will be good to invest in. However these commercial papers are issued at high denominations. As a result the retail investors like you cannot invest directly in them. Thus the only way to get exposure to them is through money market mutual funds.But like I have said in a previous post it would be better if you invest in stocks, government and corporate bonds and other higher yielding instruments.

Happy investing.

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