Commercial Paper: What Is It and How It Works

Commercial paper is a type of short-term investment instrument issued by corporations in order to cover certain types of debt liabilities. Corporations issue commercial paper when they need to cover time-sensitive financial liabilities — payroll and seasonal inventory expenses are two common needs covered by commercial paper.

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In exchange for funding these financial needs through the purchase of commercial paper, investors purchase offerings below the nominal value of the investment — the “par value” — and earn interest. The specific APR that investors earn will vary depending on the value of the investment and the length of time that the company issuing the commercial paper has to pay back what they borrowed.

The term for a commercial paper investment cannot exceed 270 days by law, with most investments being repaid in 30 days. The more time the company has to repay its loan, the more money the company will pay in interest.

Commercial paper investments have minimum denominations of $100,000. This high minimum investment amount means that retail investors rarely purchase whole commercial paper investments on their own. Other corporations and financial institutions are the primary buyers of commercial paper.

Only companies with high credit ratings may use commercial payments to cover short-term debts, as commercial paper investments represent unsecured debt.

Types of Commercial Paper

What is commercial paper exactly and how does it work? The answer might vary slightly depending on the investment instrument. There are four major types of commercial paper. The following four financial instruments are the most common commercial paper investments.

Checks

Commercial checks function in a similar way to personal checks. Commercial checks are issued as needed through banks according to instructions from the company issuing the commercial paper instrument.

Certificates of Deposit

Certificates of deposit are a type of bank receipt that confirms that a specific amount of money has been deposited to the bank by an investor. In exchange, the bank issuing the CD agrees to pay back the amount of money in the CD plus interest.

Promissory Notes

Promissory notes are legally binding agreements written from one party to another agreeing to pay a specific amount of money on a predetermined date in the future. Promissory notes are a type of basic contract, but they are one of the most common ways for companies to issue commercial papers.

Drafts

A draft is an agreement written by a bank and signed by both a company borrowing money and an investor financing the loan. The bank draws up the draft, which lays out instructions between the payer — the company — and the payee — the investor.

What Is an Example of Commercial Paper?

The following is an example of how commercial paper instruments are used on the financial market.

The manager of a business is looking to create a new product line ahead of the upcoming holiday season. Though this business has an excellent credit rating and consistent income, it does not have the liquid cash needed to fund the new collection.

The business needs $200,000 to produce their holiday collection. To entice investors, the business offers a commercial paper valued at $206,000 with a term of 30 days. If an investor loans the business the $200,000, it will return $206,000 when the term is up, thanks to an interest rate of 3%.

An investor who thinks this is a good deal will sign onto a commercial paper with the company, providing the business with $200,000 in financing. A month later, the company will return $206,000 to the investor — the balance of the original loan plus $6,000 in exchange for rush financing.

Final Take

While commercial papers can provide a layer of diversification to any investor’s portfolio, the $100,000 minimum investment can make accessing these instruments can make them inaccessible to most retail investors.

Investors who are looking to add the stability of commercial paper to their portfolios may want to consider investigating CDs from their local bank or credit union. CDs from credit unions and banks have lower minimum investments when compared to other avenues of commercial paper investing, making them a more accessible portfolio addition.

This article originally appeared on GOBankingRates.com: Commercial Paper: What Is It and How It Works