I was watching a video of the 1996 Berkshire Hathaway shareholder meeting where a member of the audience asked Warren Buffet where Berkshire kept their cash. If you watch the clip you might get some amusement from Warren casually stating “we have a billion and something in treasuries, and a little something extra in commercial paper” as though it’s just pocket change, but it was the reference to commercial paper that piqued my interest.
I understood that the basic principal of commercial paper was that a company needed to raise capital and was choosing to do so via debt. In this way, I figured that it was probably little different to a commercial bond, and yet as it had a different name I was curious whether this was purely a semantic difference or whether there were more tangible variations between the instruments.
Apparently there is.
Commercial paper is a fixed-income security with a maturity of less than 270 days which forms part of the ‘money market’ – a short-term alternative to the main capital markets. Money markets are where banks and commercial organisations trade financial instruments which are highly liquid, short-term, and a great source of working capital.
As an unsecured promissory note (a written promise by one party to repay another party with a definite sum of money, either on demand or on a specified date), the holder has no specific claim against collateral but holds a ‘promise’ that they will receive their capital back with a fixed rate of interest. This compares to a commercial bond – another type of debt security – which is generally long-term (over 270 days) and is often secured against assets.
Why is commercial paper a good source of working capital?
Commercial paper enables an organisation to raise finance for short-term financial obligations such as capital investments without the onerous requirements of applying for a business loan. In this way it is quicker and less onerous for the company to raise funds, in addition to the usual benefit of debt-based finance not giving away a share of the company.
How does commercial paper work?
Commercial paper is traditionally offered in large values – £100,000 or more is often the minimum value able to be purchased, with notes exceeding this value available in £1,000 increments. This usually precludes retail investors (who at any rate are unlikely to be investing such an enormous sum of money in a single instrument) and contrasts against commercial bonds which are more often issued in £1,000 denominations.
As commercial paper is unsecured it is also usual for it to pay a higher rate of interest than other instruments but this obviously comes with an increased level of risk as the only security a holder has is the financial strength of the institution issuing the instrument. This risk can lead to total loss of capital if the issuer defaults as an investors as little recourse available to them when seeking repayment of defaulted paper.
Would I invest in commercial paper?
Honestly, only on a very, very limited basis. The fact these instruments are unsecured doesn’t fill me with great confidence – too many commercial organisations have weak balance sheets an inconsistent levels of income for me to be comfortable ‘trusting’ them with unsecured capital. Like Warren, I would be extremely picky in deciding which organisations to lend to – the vast majority of companies would have neither to revenue or balance sheet to justify my effectively ‘giving’ them £100,000 or more in cash.