Advantages & Disadvantages of Commercial Paper

Written by corr s. pondent
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Advantages & Disadvantages of Commercial Paper
Businesses raise short-term financing by issuing commercial paper. (Jupiterimages/Photos.com/Getty Images)

Commercial paper represents one way for large firms to borrow money for the short term, typically up to nine months. The paper is rated by a credit rating agency, giving investors an idea about how risky the investment is. Typically, companies issue the commercial paper for less than its face value and buy back the paper at its face value. This discount makes up the interest to the investor. This form of investment has advantages and disadvantages.

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Relative Safety

Commercial paper is issued by large creditworthy borrowers, which means it's typically less risky than some other investments. Also, the rating provided by credit rating agencies gives an indication to investors about how risky the investment is, which helps them better gauge the investment. As a trade-off for the relative safety of this investment, it yields a lower rate than riskier investments, such as stocks.

Steady Investment

Another advantage is that commercial paper issuers usually can't buy back the paper before its due date without a penalty. This means they can't buy back the paper before its maturity without compensating the investor for the early purchase. Investors can thus count on a steady yield from commercial paper, unlike in the case of certain bonds that investors can retire before their maturity.

Lack of Liquidity

Investors may buy commercial paper and then find they need the money they invested before the security's maturity date. However, this is not a very liquid investment and there is no active secondary market. This makes it difficult for the investor to sell off the commercial paper before its scheduled maturity date.

Issuer's Point of View

Commercial paper represents a form of financing that allows the issuer of the paper to borrow money at relatively low interest rates. The availability of funding through the commercial paper market means the firm can negotiate to get bank loans, another source of financing, on better terms. From the issuer's point of view, the inability to retire the debt before the end of its term without paying a penalty is a disadvantage. The firm may want to retire the debt early and save money on interest payments.

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