What Is Commercial Paper and Why Does the Federal Reserve Care?

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First off, commercial paper is debt issued by companies. 

But it’s not the type of multi-year, high interest rate bond you know of. 

It’s short-term debt used for daily operations. 

Let’s dive in...

A company needs to buy inventory for sale for its current quarter. And it needs to pay down very short-term liabilities, like accounts payables, but it doesn’t want to use any of its own cash today. 

The company issues bonds at a very low interest rate with a term ranging from just a few days to a few months. 

Lenders and bond investors, like money market mutual funds, are happy to pay the price because this company is financial healthy and it would be a very severe circumstance that the company would be less likely than 100% to pay back the loans. 

Well, recently, the Coronavirus has had its way with the economy. Consumers are staying home, not spending. They’re spending on consumer staples an e-commerce-distributed goods. But other retail companies are getting hit. Almost all sectors are getting hit. 

So with basically no revenues coming in, companies have very limited flexibility to pay down debt, even short-term debt. The longer the no-revenue picture persists, the more of their own cash companies have to drain out to pay down debt. This makes them much less liquid. 

So lenders, for a few days, stopped lending to commercial paper issuers. Companies couldn’t access short-term financing. These dynamics can result in a lot of things, including lay-offs, which keeps the recessionary spiral going. 

And debt investors, like those money market funds, sold commercial paper assets, as investors in the funds demanded their money back in fearful mad-dash to sell anything that wasn’t cash. 

When the price of these assets fall, the interest rate rises (that’s basic bond math). Now, companies have a much higher cost of raising debt, making their liquidity situation even worse. 

So the Fed unleashed its rare powers to support the commercial paper market

Want to see how the Fed does this? Watch the quick video above. 

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