Concept
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Commercial paper refers to instruments that are also very similar in nature to treasury bills. The primary distinction between the two is that commercial papers are issued by commercial entities as opposed to national governments which issue T-bills. In this context the features of the
transaction remain the same, as the commercial entity sells the instrument, which in turn obligates them to pay a specified par value at a specified maturity.
Commercial entities (and governments) can of course issue longer-term debt instruments; that is, issue these types of debt instruments but with a maturity that is in more than a year’s time (in other words, they can seek longer term loans). In such cases, the instruments with a long maturity are usually termed bonds, which will be studied in greater detail in our next module. Conversely, short-term debt instruments are commonly termed notes or bills.
Despite their commonalities, there is an important difference between commercial paper issued by private entities, and government-issued treasury bills: governments have a much more robust ability to meet their obligation to pay the promised par value. This is because a commercial entity can go bankrupt at any time and have no money to repay it upon maturity; or it may be dissolved before an issued note has reached maturation. Although it is possible that a government ceases to exist in the short term, it is (usually) highly unlikely; and although governments can encounter financial distress, they always have the option of printing additional money in order to meet their obligations. Municipalities, which issue municipal notes, are typically stable and financially reliable institutions, but not to the extent that national governments are.
As you may recall from the previous module, this type of risk is known as default risk (or credit risk) and will be discussed in more detail in the next section, as it is a critical concept in finance. For now, we will pay attention to the fact that the prices of the instruments will reflect this default risk by virtue of supply and demand. For instance, an investor would typically prefer treasury bills to commercial paper of equal par value and maturity because the former has a larger probability of the par value being paid, and so treasury bills will command a higher price. At this stage, you may
be able to recognize the implication: the treasury bill will have a lower interest rate than the corresponding commercial paper. This idea will be outlined and discussed later.