A commercial paper (CP) which lasts between one day to 270 days, is a trade credit issued by companies (usually larger ones) that are in need of funds. The commercial paper is bought by other companies with sound liquidity facilities. They are mainly issued in the form of asset-backed securities.
Companies must meet certain conditions in order to issue out the paper, as determined by ratings by independent agencies. In principle, entities must establish management letters for the last six months to prove their financial health and creditworthiness.
The commercial paper issuer has the option of either marketing the securities to investors. Or sell to a dealer, who puts it up on the market. The dealer market entails major securities firms and in some cases subsidiaries of bank holding firms.
While direct issuers are often financial organizations which have regular funding needs and favor selling direct in order to save on dealer fees. This saving counterbalances the expense of sustaining sales employees to market the paper.
In comparison with other credit options, the commercial paper is a much cheaper alternative. However, this is dependent on the size and creditworthiness of a business, even though some companies still retain bank lines of credit as a second option.
In some EU countries, financial rating by a rating agency (such as S & P, Moody’s or Fitch) is not required if the issuer is listed on an exchange or if there are any listed bonds of the same issuer.
The lending rates are especially cheap for companies (although smaller than for lines of credit). They are usually higher than a few basis points (or Basis point 1bp = 0.01%) in the EONIA swap of the same maturity.
The gap with the swap spread also called emission depends on several factors which include the credit quality of the issuer (the spread increases with risk), the duration of emission (the spread increases with the duration). The more or less market liquidity (the spread increases when liquidity declines).
In many jurisdictions, the CP transactions are almost entirely intermediated by banks and to a lesser extent by the brokers. The banks act as an agent distributor (dealer) but compared to other dealers they hold the advantage of making the underwriting. They can then keep a portion of the CP in case of resale, even if they also carry credit risk in their books.
Advantages of commercial paper include the fact that its broad array of maturity renders more flexibility, high credit ratings translate to a lower cost of capital, no lien created on asset of the firm, and investors can exit the CP due to its favorable tradability.
While its disadvantages pertain to the lowering of credit limits by banks, the paper is only available to big businesses, the need for credit options for issuer and the fact that issuer brandishes greater control in CP issuance.