Short-term products

Now that we’ve discussed the fundamental concepts of debt securities, let’s cover bond types. We’ll start with short-term debt obligations issued by corporations (businesses).

Commercial paper

Commercial paper is the primary security issued when a corporation plans to borrow short-term funds. Whether the organization needs money for payroll, acquisition of property or equipment, or for any other reason, issuing commercial paper is a great way to raise capital quickly with few regulatory restrictions or requirements in place. Before we analyze why this type of security is lightly regulated, let’s discuss how it works.

Issued at a discount and maturing at par, commercial paper is one of a few prominent zero coupon debt securities to be aware of. It does not pay ongoing interest semi-annually like most other debt securities. Instead, interest is considered payable at maturity. Commercial paper is typically issued with par (face) values of $100,000 or more ($1 million is common). The large denominations are most suitable for institutional investors with significant investment capital. Due to their size, most retail investors cannot afford commercial paper. However, large financial institutions buy and repackage these securities into affordable investments for retail investors (e.g., money market funds). This topic is covered in more depth later in the investment companies unit.

Let’s go through an example to demonstrate how an investor makes a return on commercial paper. Assume Coca-Cola Co. needs to borrow roughly $1 million to acquire new equipment for a beverage distribution center. To do so, the company issues $1 million par value six-month commercial paper at a discounted price of 97% of par value. An investor would purchase the security for $970,000 (97% of the $1 million par value), hold it* for six months, and then receive $1 million at maturity. The $30,000 difference is the interest paid to the investor.

*Investors are not required to hold debt securities to maturity. Most debt securities can be sold to other investors at the going market price before maturity.

The maximum maturity for commercial paper is 270 days. It may seem like a random number, but it relates to something specific. We’ll discuss the Securities Act of 1933 in the primary market chapter, the key federal legislation covering the sale of new issues. The law typically requires issuers to register securities with the Securities and Exchange Commission (SEC) before public sale. This process requires issuers to disclose all essential facts about the security to provide potential investors with enough information to make an informed investment decision.

Registration involves significant investments of time and money. The issuer must hire lawyers, accountants, and other professionals to fulfill SEC registration requirements (making full disclosure, filing the appropriate paperwork, etc.). Additionally, the issuer must pay a significant fee to file the required documents. For example, AirBnB Inc. paid a $109,100 fee when registering its stock for its 2020 initial public offering (IPO). This process is exhausting and only followed if required by law.

The SEC provides exemptions (exceptions) to their registration process. Several are essential for the exam and will be discussed in a future chapter. For now, we’ll only focus on one:

Debt securities issued with 270 days or less to maturity are exempt from SEC registration requirements

Why doesn’t the SEC require corporate issuers to register debt instruments with 270 days or less to maturity (commercial paper)? Short-term debt securities are usually safe and avoid many risks investors assume with long-term bonds. The issuer must go bankrupt within the next 270 days for the investor to lose their entire investment. This is unlikely to happen “out of the blue” for most larger, well-established companies, which are the primary issuers of commercial paper.