Difference Between Commercial Paper, Certificates of Deposit, and Bonds
Commercial paper is a short-term, unsecured debt instrument that plays a vital role in modern commerce and financial management. It is primarily issued by large, creditworthy corporations to meet their immediate funding needs, such as financing payrolls, inventories, or other short-term liabilities. Instead of turning to conventional loans, companies use commercial paper to access quick capital at competitive rates by selling these notes directly to investors. The key attribute is its short maturity—ranging from just one day up to 270 days—and the fact that it is not backed by collateral.
Definition and Key Principles
Commercial paper represents a promise by the issuing corporation to pay a specific amount (the face value) to the investor on a set future date. It is almost always issued at a discount to its face value, meaning investors purchase it for less and earn a return equal to the difference upon maturity.
Only financially strong companies with excellent credit ratings are trusted to issue commercial paper because, without collateral, investors rely solely on the issuer’s reputation and financial health for the security of their investment.
Characteristics of Commercial Paper
- Unsecured: Not secured by any asset; relies on the issuer’s credit.
- Short-term: Maturities range from 1 to 270 days, with average terms around 30 days.
- Issued at Discount: Sold below face value; investor earns the difference upon maturity.
- Large Denomination: Minimum size is generally $100,000, making it most accessible to institutional investors.
- Low Registration Need: Does not require registration if maturity is under 270 days.
How Commercial Paper Works: Practical Example
Suppose a company needs to cover a temporary gap in cash flow and decides to issue $1,000,000 in commercial paper with a 60-day maturity. It sells these notes to investors for $990,000. After 60 days, the company repays the full face value ($1,000,000), and investors realize a $10,000 gain.
This practice helps both sides: the company gets immediate funds at a lower cost than a bank loan, and investors get a relatively safe, short-term investment with predictable returns.
| Term | Definition & Role |
|---|---|
| Issuer | Company or institution selling commercial paper to raise funds quickly. |
| Face Value | The amount to be repaid at maturity; bought at a discount by investors. |
| Maturity/Term | Duration until repayment, up to a maximum of 270 days. |
| Discount | Sale price below face value—the return to the investor. |
| Unsecured | No collateral backing, higher dependence on issuer's reputation. |
Formulas and Yield Calculation
To calculate the return or yield on commercial paper:
Discount Yield (%) = [(Face Value - Purchase Price) / Face Value] × (360 / Days to Maturity) × 100
Annualized Yield (%) = [(Face Value - Purchase Price) / Purchase Price] × (365 / Days to Maturity) × 100
These formulas allow both issuers and investors to assess and compare short-term debt alternatives.
Advantages and Limitations
| Advantage | Limitation |
|---|---|
| Cheap, quick source of funds for companies | Only highly-rated issuers can use commercial paper |
| Investors enjoy portfolio diversification | High minimum denomination—out of reach for many small investors |
| Lower cost than loans; flexible maturity | Use limited to short-term, not for capital investments |
Commercial Paper vs. Bonds: Key Differences
| Feature | Commercial Paper | Bonds |
|---|---|---|
| Maturity Period | 1–270 days | 1 year or more |
| Collateral | Unsecured | Can be secured or unsecured |
| Who can buy? | Large institutions | Institutions and retail investors |
| Interest Type | Discount-based | Regular coupons/interest |
Who Issues and Buys Commercial Paper?
Issuers are generally large, stable corporations or financial institutions with solid credit history. Typical buyers include investment companies, pension funds, state and local governments, and other large-scale investors. Because of the high face value, small investors usually get exposure through money market funds and similar vehicles.
Risks and Considerations
While commercial paper is perceived as low-risk due to the issuers’ creditworthiness and short maturities, it is not risk-free. The main risk is that the company could default, leaving investors without recourse since the instrument is unsecured. This is why only the most reliable companies can participate.
Practice and Learning Resources
- Work on practical examples and solved problems about yield and pricing of commercial paper.
- Review commercial paper concepts in related topics by exploring Vedantu’s Accounting, Business Studies, and Economics sections.
- Join live sessions and interactive questions for more practice.
For further topics including accounting for securities, short-term financing strategies, and comparative analysis of debt instruments, continue exploring related resources on Vedantu’s Commerce platform.
FAQs on Commercial Paper: Definition, Features, and Importance in Commerce
1. What is commercial paper?
Commercial paper is an unsecured, short-term debt instrument issued by corporations or financial institutions to meet immediate funding needs. It typically matures in 7 to 270 days, is issued at a discount, and is redeemed at face value.
2. Who can issue commercial paper in India?
Commercial paper can be issued in India by corporations, primary dealers, and all-India financial institutions that meet eligibility norms set by the RBI. The issuing company must have:
- A tangible net worth of at least ₹4 crore
- A minimum credit rating (as per RBI guidelines)
- Sound financial health and compliance with applicable norms
3. Why is the maximum maturity of commercial paper limited to 270 days?
The maximum maturity of 270 days ensures that commercial paper remains a short-term money market instrument. This keeps it outside the scope of long-term regulatory requirements and aligns with RBI and global money market practices.
4. Is commercial paper a secured or unsecured instrument?
Commercial paper is unsecured. It is not backed by any collateral, and its safety depends on the credit rating and financial health of the issuing company.
5. What are the main features of commercial paper?
Key features of commercial paper include:
- Short-term maturity: 7 to 270 days
- Issued at a discount and redeemed at face value
- No collateral
- Tradable in the secondary market
- Issued by highly rated companies
6. How is commercial paper different from bonds?
The differences between commercial paper and bonds are:
- Tenure: CP is short-term (up to 270 days); bonds are long-term (over 1 year)
- Security: CP is unsecured; bonds can be secured or unsecured
- Issuers: CP is issued by companies; bonds by governments and firms
- Interest: CP is issued at a discount; bonds pay periodic interest (coupon)
7. Who can invest in commercial paper?
Banks, mutual funds, insurance companies, and institutional investors can invest directly in commercial paper. Retail investors generally do not participate due to high minimum investment requirements.
8. How is the return or interest on commercial paper calculated?
The return on commercial paper is the difference between its face value and issue price. The annualized yield can be calculated using:
- Annualized Yield = (Interest Earned / Issue Price) × (365 / Number of Days) × 100
- Interest Earned = Face Value – Issue Price
9. What is the difference between commercial paper and certificates of deposit (CDs)?
Commercial paper is unsecured and issued by corporations, while certificates of deposit (CDs) are term deposits issued by banks and can be secured or unsecured. CDs may have a fixed or variable rate; CP is always issued at a discount.
10. Is commercial paper risk-free?
No, commercial paper is not risk-free. Its safety depends on the credit quality of the issuing company, and there is potential credit risk if the issuer defaults.
11. Can individuals invest in commercial paper in India?
Individuals usually cannot invest directly in commercial paper due to the high minimum denomination (typically ₹5 lakh or more). However, retail investors can invest indirectly via mutual funds and other pooled vehicles that invest in money market instruments.
12. What are typical uses of funds raised through commercial paper?
Funds raised via commercial paper are primarily used for working capital, managing short-term liabilities, inventory, and other immediate liquidity requirements. They cannot be used for long-term investments or for acquiring fixed assets.
