Commercial Paper: Meaning, Types
Commercial paper is short-term, unsecured notes corporations use to raise funds and avoid bank borrowing. It’s also used for bridge financing and corporate takeovers.
What is Commercial Paper?
Commercial paper is a short-term unsecured promissory note issued in the open market that represents the obligation of the issuing corporation. The issuance of commercial paper is an alternative to bank borrowing for large corporations (non-financial and financial) with strong credit ratings.
While the original purpose of the commercial paper was to provide short-term funds for seasonal and working capital needs, companies have used this instrument for other purposes in recent years. It has been used quite often for bridge financing.
For example, suppose that a corporation needs long-term funds to build a plant or acquire equipment. Rather than immediately raising long-term funds, the corporation may postpone the offering until more favorable capital market conditions prevail.
The funds raised by issuing commercial paper are used until longer-term securities are sold. Commercial paper has sometimes been used as bridge financing to finance corporate takeovers.
Issuers of Commercial Paper
Corporate issuers of commercial paper can be divided into financial and non-financial companies. Financial companies issued the majority of Commercial paper outstanding. As of June 1997, financial firms issued 78% of all commercial paper outstanding.
3 Types of Financial Companies That Issue Commercial Paper
There are three types of financial companies;
- captive finance companies,
- bank-related finance companies, and
- independent finance companies.
Captive finance companies are subsidiaries of equipment manufacturing companies. Their primary purpose is to secure financing for the parent company’s customers.
For example, the three major U.S. automobile manufacturers have captive finance companies: General Motors. Acceptance Corporation (GMAC), Ford Credit, and Chrysler Financial.
GMAC is by far the largest issuer of commercial paper in the United States.
Furthermore, a bank holding company may have a finance company subsidiary that provides loans to enable individuals and businesses to acquire a wide range of products.
Independent finance companies are not subsidiaries of equipment manufacturing firms or bank holding companies.