Commercial paper

Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper range from 1 to 270 days. . Commercial paper is the largest component of the U.S. money market, and is a common investment vehicle found in U.S. money market funds. Commercial paper is not unique to the U.S. market, as it is issued in many national money markets. Similar to Treasury bills, commercial paper is usually issued at a discount and is redeemed at face (par) value. The difference between these two values constitutes the interest earned by the investor.

History
In the U.S. commercial paper markets began in the nineteenth century, with non-financial firms such as textile mills and railroads issuing short term paper. In 1919 the founding of General Motors Acceptance Corporation (GMAC) extended the commercial paper market to financial firms. The growth of consumer financing (autos and durable consumer goods sold with credit issued by finance companies) further expanded financial firm commercial paper. Demand for commercial paper grew with the creation of the money market mutual fund in the 1970s. Innovations in the 1980's included the growing dominance of dealer sold commercial paper (over direct company issuance) and the creation of Asset-Backed Commercial Paper Conduits (ABCP).

In 1970, the collapse of Penn Central, a transportation company, led to the company defaulting on its commercial paper. Loss of investor confidence following this default resulted in investors refusing to refinance maturing commercial paper. Aggressive lending by the Federal Reserve provided liquidity and stabilized the market.

In 2007 defaults in Bear Stearns hedge funds and term extensions in the ABCP market created a sequence of institutional "runs" on ABCP paper. The 2008 default of Lehman Brothers' commercial paper resulted in a money market fund, The Reserve Fund, "breaking the buck", with losses culminating in a 97 cent per share value, and a shutting off of redemption. The loss of liquidity resulted in a massive institutional run on money market funds, a sharp spike in commercial paper rates, and a growing lack of liquidity in the market. To preclude additional runs and bring back liquid markets, the Federal Reserve instituted multiple "funding facilities" to the commercial paper market and money market funds. These programs expired in 2009 and 2010.

Market structure
Commercial paper is loosely defined by issuer:
 * Non-financial firm commercial paper;
 * Financial firm commercial paper;
 * Asset-backed commercial paper.

The following charts show the amount of commercial paper outstanding over the years 2000-2012. Figure 1. provides data for the entire commercial paper market. Figures 2. through 4. provide data from each issuer.

Standard and Poors provides the S&P Commercial Paper Index, which consists of three indices: S&P U.S. Commercial Paper Index (Total Return); S&P U.S. Commercial Paper Financials Index (Total Return); and S&P U.S. Commercial Paper Non-financials Index (Total Return). The indexes do not include asset-backed commercial paper. The index composition consists (2010) of 84% financials and 16% non-financials.

Commercial paper is also classified by its distribution, as direct sold paper and dealer sold paper. Dealer sold paper is the dominant distribution method.

Financial regulations also classify paper according to risk ratings provided by national credit rating firms (Standard & Poors, Moody's and Fitch). Paper is divided into Tier One paper and Tier Two paper. Money market funds are required by regulation to limit investment in Tier Two paper.

Risk and return
As the history of the commercial paper market indicates, commercial paper is exposed to credit risk of default, as well as "rollover' risk, the risk that investors will refuse to refund paper once an issue has matured. As a result, commercial paper provides higher interest rates than Treasury bills. Credit ratings ascribed to commercial paper from rating agencies is provided in the following table.

Current interest rates on commercial paper are provided by the Federal Reserve Historical interest returns are available from the St.Louis Federal Reserve. The charts below provide data from 1970 - 2012. These charts reflect the high interest rates prevalent during the high inflation years between 1970-1981 and the subsequent fall in rates coincident with the disinflation prevalent over the 1980-2012 period. The Figure 6. chart illustrates both the spike in rates during the 2008 financial crisis, as well as the subsequent fall in rates to near zero coincident over the "Great Recession" years (2008-2012). Note that the Figure 5. chart has been discontinued and that there is a difference in scale between the two charts.