For traditional businesses, the primary source of debt finance was financial institutions. However, with modern corporations, conventional methods changed. While companies still have the option to obtain debt from financial institutions, they also have other options. These options come in the form of commercial papers or bonds that a company can issue.
What is a Commercial Paper?
Commercial paper is a type of debt instrument that is short-term and unsecured. Most companies issue these to finance their short-term needs. These needs may include working capital shortages, financing payroll, paying operating expenses, etc. Commercial papers have short maturities. They can range between a few days to almost a year.
Commercial papers come at a discount price with a promise of a higher face value at maturity. Since these are short-term instruments, investing in these papers is highly attractive for investors. Similarly, for companies that issue these, obtaining finance is effortless due to their liquidity and marketability. The only risk factor for investors may be their unsecured nature.
Companies can issue commercial papers in one of two ways. Firstly, they may distribute them directly to investors. However, some companies may also use dealers or brokers to issue them. The dealer then takes the responsibility of selling them but may charge a commission for their work. They also come with fixed interest rates and payments, which make them similar to bonds.
There are different types of commercial paper that companies may issue. These include notes, which is a written promise from companies. They may also come as drafts, which is a written agreement and involves a bank. Similarly, they may come in the form of checks. The most prevalent type of commercial paper is a certificate of deposit (CD).
What is a Bond?
A bond is one of the primary types of debt instruments. These usually come with a fixed-income. With bonds, the issuer may be companies, governments, or even projects. Like any other debt instrument, the purpose of issuing bonds is to finance the issuer’s needs. They also come with a face value that is the amount that investors get at the bond’s maturity. Similarly, the interest payments may depend on the face value for most bonds.
Bonds are a common type of investment for most investors. These are fixed-income securities that offer a steady and stable source of income. However, bonds are longer-term compared to commercial papers. Therefore, the returns that investors get on these securities are also long-term. However, they come with higher risks, specifically credit risk.
The primary purpose of bonds is to finance long-term needs rather than short-term. While some bonds may also be short-term (less than three years), they still last longer than commercial papers. Similarly, some bonds may also be medium-term (four to ten years) or long-term (more than ten years).
Compared to commercial papers, bonds come in a wide variety of forms. For example, they may come with a fixed rate, floating, or even zero interest rates. Some bonds also come with conversion or call options. Depending on their source, bonds may also be corporate or municipal. Overall, there are more types of bonds.
Commercial papers and bonds are debt instruments issued by companies and other entities. Commercial papers are usually short-term debt instruments that can last up to a year. On the other hand, bonds last longer.