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Asset-backed commercial paper is a short-term financing option for businesses, often used to meet immediate cash flow needs. It can be backed by collateral and is repaid when accounts receivable are due. It provides liquidity to an economy, but there is a risk of default if loans are made to non-creditworthy companies.
Almost every business, whether small or large, will at some point struggle to meet its short-term cash flow needs. It is very common for a company in this situation to use a form of short-term financing known as commercial paper. A commercial paper loan typically matures in three to six months. Sometimes commercial paper is backed by some type of collateral, in which case it is known as asset-backed commercial paper.
In a typical situation, asset-backed commercial paper is purchased by a company that intends to repay the loan when accounts receivable are due—in other words, when their customers pay them money they’ve already promised to pay. If a business needs short-term money for inventory or payroll, for example, it can purchase an asset-backed commercial paper loan to meet these immediate needs. Then, when customers’ accounts come due, the loan is repaid with that money.
Although it is also common for businesses to maintain lines of credit with banks, it is often better for businesses to use asset-backed commercial paper as it carries a lower interest rate. Lines of credit serve as a kind of safety net, used when cheaper options are out of stock or unavailable. While commercial paper can be a much-needed lifeline for a company with immediate financial obligations, this is not the only purpose it serves.
In a broader sense, asset-backed commercial paper helps provide liquidity to an economy, which means the easy availability of cash. Liquidity is very important for the functioning of economies everywhere. It is of great concern when this liquidity is lost, as happened in 2008 when commercial paper suddenly but briefly became unavailable as part of a larger economic crisis in the United States.
Institutions that provide short-term loans to businesses can in turn issue this debt to investors. When investors buy the right to collect debts, this investment is what technically constitutes a commercial paper, although this term is used colloquially to also refer to the loan itself. The bank that originally issued the loan, if it sells the debt to a third party, is released from the obligation to collect it. This can lead to a major disadvantage of asset-backed commercial paper, which is a potential lack of discipline on the part of lending institutions. If a loan is made to a company that is not creditworthy or unable to repay it, the risk of default increases, making investors less likely to buy commercial paper and thus a lack of liquidity.
Smart Asset.
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