Types of Commercial Paper: Promissory Notes, BA, CDs, Repos & T-Bills

Commercial paper is one of the most critical financial instruments used in the corporate and banking world for short-term borrowing. Firms and financial organizations make extensive use of various types of commercial papers for working capital purposes and liquidations. Thus types of commercial paper can be an important topic to know for anyone interested in studying finance or accounting in modern times.

Meaning of Commercial Paper

Commercial paper is an unsecured, short-term debt instrument issued by companies or financial institutions to raise immediate funds. Such instruments are used by firms with high credit ratings and are meant to offer liquidity at a lower cost than traditional loans. The types of commercial paper differ depending on the purpose, terms, and characteristics.They are a key component of the money market, offering a low-cost borrowing option for companies while providing a relatively safe and liquid investment choice for institutional investors.

Types of Commercial Paper

Promissory Notes

A promissory note is a very simple commercial paper where the issuer promises to pay a certain amount on a certain date. The promissory note is highly utilized in business finance. A promissory note is simple debt paper issued to the holder promising a specific amount on a given date. 

Features of promissory notes

These instruments depend on the creditworthiness of the issuer and are generally used for short-term financing by companies to meet immediate cash flow requirements

• Written Document: A written document where the issuer promises to pay a certain amount. Fixed repayment date and interest rate.
• Maturity: Generally it is issued without security, depending on the issuer’s creditworthiness. Maturity usually ranges between 30 days to 270 days.

Advantages of promissory notes

Promissory notes are an efficient method through which businesses can raise funds with minimal documentation and no collateral. The simplicity and flexibility of promissory notes make them an attractive source for both the issuer and investor looking for simple financial solutions.

• Simple: It is simple and easy to issue. Flexible terms that can be tailored between the issuer and holder.
• Interest: It has lower interest rates compared to traditional loans. No collateral is required, hence there is minimal procedural delay.

 Disadvantages of promissory notes

The risk factor associated with promissory notes, due to their lower creditworthiness and short-term financial objectives, makes their usage limited.

• Risk: High credit risk as it is dependent on the issuer’s creditworthiness; low marketability compared to other instruments like CDs.
• Suitability: Not appropriate for investors seeking a long-term investment option Banker’s Acceptances

Banker’s Acceptances

Banker’s acceptances are a kind of commercial paper that is accepted by a banker. A Banker’s Acceptance (BA) is a financial instrument that acts as a time draft drawn on and accepted by a bank. It is typically used in international trade and is a commitment by the bank to pay the holder a specified amount at a future date. Essentially, the bank guarantees the payment, making it a secure form of financing for both the buyer and seller in trade transactions.

Features of Banker’s Acceptances

 Banker’s acceptances are short-term instruments where credit reliability is enhanced due to a guarantee by a bank. These are usually used for international trade, and ensuring payments, and are very liquid in secondary markets.

• Guaranteed by Bank: A guarantee by a bank enhances credit reliability. Commonly used for financing international trade.
• Liquidity: It is quite liquid, frequently traded on secondary markets. Short-term maturities are usually less than 180 days.

Advantages of Banker’s Acceptances

 The factor of banks increases the credibleness of banker’s acceptances, hence banker’s acceptances are reliable for trade financing

• Creditworthiness: It has high bank creditworthiness. Easier to transfer and hence trade, hence liquid
• Practicality: Practical for maintaining cash flow in international business transactions. Less risk associated with it.

Disadvantages of Banker’s Acceptances

Although secure, banker’s acceptances are only suitable for a narrow range of transactions and are mostly used for trade finance.

• Usage: it has very limited usage outside of trade finance. Exposed to the credit risk of the guaranteeing bank; at risk if the guaranteeing bank defaults.
• Flexibility: It is not as flexible as promissory notes in forming terms.

Certificates of Deposit (CDs)

Certificates of deposit are time-deposit products offered by banks or other financial institutions. These are low-risk instruments.

Features of CDs

Certificates of deposit are time-deposit instruments issued by financial institutions. They offer a fixed interest rate and maturity, providing a secure and predictable investment option for risk-averse investors.

• Issue: It is issued by banks and financial institutions. Fixed interest rate and predetermined maturity date.
• Negotiation: It can be negotiable or non-negotiable. Maturities range from a few months to several years.

Advantages of CDs

CDs are highly secure investments backed by financial institutions, offering guaranteed returns. The advantages include

• Risk: It has low risk and is supported by the issuing financial institutions. Predictable returns since the interest rates are fixed.
• Ideal: It has ideal for conservative investors who want stability. It is negotiable in secondary markets.

Disadvantages of CDs

The inflexibility of CDs since withdrawals made before maturity attract a penalty. Disadvantages include:

• Penalties: Penalties for early withdrawal reduce flexibility. Lower returns compared to risky investments such as stocks or bonds.
• Investment: Minimum investment is required, which may limit access.

Repurchase Agreements (Repos)

Repos are agreements in which a seller agrees to repurchase a security at a later date for a predetermined price. These are short-term borrowing mechanisms often used by banks and financial institutions.

Features of Repos

Repurchase agreements are short-term borrowing instruments where securities are sold with an agreement to repurchase them at a predetermined price. 

• Agreement: An agreement to sell securities and repurchase them later at a fixed price. Usually backed by government securities as collateral.
• Time: Extremely short-term, overnight, up to one year. Repurchase agreements are used by banks and financial institutions to manage liquidity.

Advantages  of Repos

 Repos offer immediate liquidity with minimal risk due to the collateral backing. Their short duration and flexibility make them a preferred tool for financial institutions managing short-term cash requirements.

• Risk: Extremely low-risk because of the collateral backing. Offer liquidity immediately to the issuer.
• Regulated: Highly regulated and secure, thereby earning trust in transactions. Comes with flexible terms based on requirements.

Disadvantages  of Repos

Repos are majorly suitable for institutional investors as they are not readily available to retail participants. Repos have low returns due to their short maturity periods. They are also reliant on the value of the collaterals.

• Accessibility: Retail investors has no accessibility, They are institutional. Returns are relatively low due to very short maturity dates.
• Value: Dependent on collateral value, which might go up or down.

Treasury Bills

Treasury bills, as short-term government instruments meant to meet the requirements of public finances, are issued by the government. Although they are not a corporate instrument, T-bills are relevant in the talks of commercial paper due to their involvement with financial markets.

Features of Treasury Bills

Treasury bills represent government-backed, short-term, sold at discounted prices and later redeemed to face value. They make for a key investment as they are both risk-free and quite liquid.

• Risk: The risk is taken away by the issuing of the government. No interest payments is made. It is sold at a discounted price and redeemed face.
• Maturity: The maturity ranges from a few days to one year. Quite liquid and tradable

Advantages  of Treasury Bills

Almost completely risk-free because its security is issued by the government, hence high liquidity to lots of investors. Mostly investors will be assured of steady demand.

• Risk: No risk about credit. It is issued on guarantee from the government.
• Liquidity: It is highly liquid, which is ideal for quick cash needs. Simple investment option with assured returns.

  Disadvantages  of Treasury Bills

Low returns on T-bills make them less attractive to growth-oriented investors. Furthermore, their short-term nature may not be in tandem with long-term investment plans.

• Return: It provides lower returns compared to corporate instruments such as promissory notes. It is not ideal for long-term investors due to short maturities.
• Growth: It has limited growth potential since they are fixed-income instrument.

Types of Commercial Paper FAQs

What are the primary types of commercial paper?

These are promissory notes, banker’s acceptances, certificates of deposit, repurchase agreements, and treasury bills.

In what way is commercial paper different from loans?

While commercial paper is short-term and unsecured, the loans are secured and sometimes have long terms.

Why do corporations use commercial paper?

The preference of corporations for it is on grounds of lesser cost, adaptability, and quicker procedure for issuance.

Is commercial paper the same as treasury bills?

Although technically issued by governments, treasury bills are often lumped in with commercial paper because of their use in short-term funding.

Is commercial paper safe to invest in?

It is, depending on the creditworthiness of the issuer. Banker’s acceptances and treasury bills are relatively safer.