Short-term products

Now that we’ve covered the fundamentals of debt securities, let’s look at common bond types. We’ll start with short-term debt obligations issued by corporations.

Commercial paper

Commercial paper is a common security corporations use when they need to borrow money for a short period of time. A company might need funds for payroll, to buy property or equipment, or for other short-term business needs. Commercial paper can raise capital quickly and, as you’ll see, it often faces fewer regulatory requirements than longer-term securities.

Commercial paper is typically issued at a discount and matures at par. That makes it a well-known example of a zero coupon debt security. Unlike most bonds, it doesn’t pay interest every six months. Instead, the investor’s interest is the difference between:

• the discounted purchase price, and
• the par value paid at maturity

Commercial paper is usually issued in large denominations, often with par (face) values of $100,000 or more (with $1 million being common). Because of these large denominations, commercial paper is generally purchased by institutional investors with substantial capital. Most retail investors can’t buy it directly, but large financial institutions may buy and repackage commercial paper into products that are accessible to retail investors (e.g., money market funds). This is covered in more depth later in the investment companies unit.

Let’s walk through an example to see how an investor earns a return on commercial paper. Assume Coca-Cola Co. needs to borrow about $1 million to acquire new equipment for a beverage distribution center. The company issues six-month commercial paper with a $1 million par value, priced at 97% of par.

• Purchase price: $970,000 (97% of $1,000,000)
• Value at maturity: $1,000,000
• Interest earned: $30,000

An investor buys the commercial paper for $970,000, holds it for six months, and receives $1,000,000 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. That number matters because it connects to the Securities Act of 1933, which we’ll cover in the primary market chapter. This law generally requires issuers to register securities with the Securities and Exchange Commission (SEC) before selling them to the public. Registration is designed to ensure investors receive enough information to make an informed decision.

Registration can be expensive and time-consuming. Issuers typically hire lawyers, accountants, and other professionals to meet SEC requirements (full disclosure, filing documents, and related work). They also pay filing fees. For example, AirBnB Inc. paid a $109,100 fee when registering its stock for its 2020 initial public offering (IPO). Because the process is demanding, issuers generally complete it only when the law requires it.

The SEC provides exemptions (exceptions) from registration. Several are important for the exam and will be covered in a future chapter. For now, focus on this one:

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

Why doesn’t the SEC require registration for corporate debt with 270 days or less to maturity (commercial paper)? In general, short-term debt carries fewer risks than long-term bonds. For an investor to lose their entire investment, the issuer would need to go bankrupt before the commercial paper matures. For many large, well-established companies (the primary issuers of commercial paper), that’s less likely to happen without warning over such a short time frame.