Commercial paper

Commercial paper is a money market security issued by large banks and corporations. It is generally not used to finance long-term investments but rather to purchase inventory or to manage working capital. Maturities on commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing market interest rates. Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.

It is commonly bought by money funds (the issuing amounts are often too high for individual investors), and is generally regarded as a very safe investment. As a relatively low risk option, commercial paper returns are not large. There are four basic kinds of commercial paper: promissory notes, drafts, checks, and certificates of deposit.

A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months (270 days), making it a very cost-effective means of financing. The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.

Commercial paper essentially can be compared as an alternative to lines of credit with a bank. Once a business becomes large enough, and maintains a high enough credit rating, then using commercial paper is always cheaper than using a bank line of credit. Nevertheless, many companies still maintain bank lines of credit to act as a "backup" to the commercial paper. In this situation, banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, if the company ever actually needs to use the line of credit it would likely be in serious trouble and have difficulty repaying its liabilities.

Financial-company paper is issued by firms in commercial, savings and mortgage banking; sales, personal and mortgage financing; factoring; finance leasing and other business lending; insurance underwriting; and other investment activities.