What is a Commercial Paper?
Commercial paper (CP) is an unsecured money market instrument issued primarily by financial institutions and highly rated corporate borrowers and is issued at a discount in denominations of Rs. 5 lakh or multiples thereof.
Institutional investors, such as mutual funds and insurance companies, are buyers of commercial paper. This is a common funding mechanism large businesses use for short-term debt commitments such as current liabilities, operations, monthly payments, and taxes.
The main purpose the paper serves is to help companies meet their short-term liabilities. In addition to this, it attracts fixed interest rates and commercial papers that are issued under the directive guidelines issued by the RBI (Reserve Bank of India).
How Does Commercial Paper Work?
Issuers prefer commercial paper to minimise the expense and time involved in applying for business loans, attracting heavy interest rates. Primary dealers and all-India financial institutions issue commercial paper. Corporate borrowers and satellite dealers who are authorized to raise debt through money market instruments within limits set by the RBI can also issue CPs.
When a corporation repays commercial paper, it also pays interest at the same time as principal repayment.
The proposed amount shall be raised within a duration of two weeks from the commencement date of the issue and can be issued on a single date or on different dates in parts.
Features of Commercial Paper
Following are the reasons why CP is a preferred debt instrument, among others:
- Convenient and inexpensive: It is less expensive as compared to a bank loan, and convenient to issue. Thus, businesses prefer to take up commercial paper to meet their short-term liabilities.
- Higher Interest Rates: Besides any major debt instrument, they offer higher interest rates with fixed returns. This attracts investors to CP, more than any other short-term debt instrument out there in the market.
- Instrument based on trust: Large corporations and financial institutions typically issue commercial paper because of their strong credit profiles. Unsecured promissory notes have widespread market confidence that they will be paid back.
A corporate would be eligible to issue a commercial paper on fulfilment of the following conditions:
- Free from specific transactions: CP is not tied to any specific transactions. In this way, CPs differ from other short-term money market instruments.
Types of Commercial Paper
Primarily, there are four types of Commercial paper in the market:
- Promissory Note: It is a note of promise to repay the money back, along with interest. The maker of a promissory note promises the bearer of the note of payment to the bearer of the note. The payee can be a person holding the promissory note, or a recipient entitled to receive payment.
- Draft: A draft involves three-parties, a bank(as the drawer), a payer(as the drawee), and the payee(who will be given the money). The drawer bank gives the payment order to the drawee to pay the amount due to the payee.
- Drafts (or bills of exchange): It help to secure payment in shipping transactions. The issuer of the commercial paper is given instructions by the bank to pay the payee a certain sum of money at a particular time. Buyers who want to ensure the accuracy of goods before payment request drafts, while sellers may not want to rely solely on the buyer’s promise and want payment before delivery. Therefore, sellers prefer such notes.
- Cheque: Cheques are bank-drawn commercial paper. The holder or a specified person can demand payment. The bank needs to pay the individual or business for the money in their bank account. It promises to pay the cheques from accounts with enough money.
- Certificate of Deposit: A certificate of deposit (CD) is a written confirmation by a bank that it will accept a deposit of a certain amount of money from a customer for a certain period. Following maturity, the bank has committed to repaying the principal plus interest. The CD maker and drawee are the banks, while the CD payee is the person making the deposit.
Benefits of Commercial Papers
- Simplicity and Flexibility in financing: The Reserve Bank of India (RBI) will not have to register if it matures in less than one year. This makes it an economical and straightforward method of financing.
- Lower Interest Rates: It offers issuers the advantage of lower interest rates. In addition to this, it is unsecured and thus does not create any liens on the assets of the company.
- Transparency and ease of raising funds: It does not contain any restrictions and is highly secure. Moreover, this is the best way for the company to take advantage of short-term interest fluctuations in the market.
- Easier to get as compared to other debt instruments: Dealing with commercial paper is easier in comparison to the amount of work, time and money needed to acquire a loan.
- Securitization of funds: They offer investors a low risk of default, hence increasing their credibility in the market.
- Diversification: They provide an effective way for investors to diversify their portfolios.
Risks of Commercial Papers
- Credit Rating: Only large companies with high credit ratings can sell commercial paper at a reasonable rate due to its promissory nature. Only “blue-chip” companies can issue debt instruments without collateral. If a smaller company tried to issue commercial paper, investors will not buy the securities. The credit risk, or possibility of a borrower defaulting, will be too high for smaller organisations, and there will be no market for this issue.
- Liquidity: Liquidity is another risk, though it is lesser than with longer-term debt. It is the ability to convert a security into cash at its fair value. Liquidity shows how easily a security can be bought or sold.
It is less of a concern than credit (default) risk because the debt matures quickly, leaving little room for secondary market trading. Despite being one of the most used money market debt instruments, secondary markets are small.
- Risk of repayment to investors: There is no guarantee that investors will receive their money back, and it might question the instrument’s credibility.
Frequently Asked Questions
It is generally issued by large corporations, primary dealers, and All-India Financial Institutions (FIs). Ideally, they issue commercial paper to meet working capital requirements or short-term obligations.
The following criteria for issuing a commercial paper:
The working capital limit has to be sanctioned by banks or all-India financial institutions.
The tangible net worth of the firm issuing a commercial paper is not less than Rs. 4 crores.
Minimum credit rating of P-2 from CRISIL or equivalent rating from ICRA/CARE.
Commercial paper maturities extend from 1 to 364 days, whereas bonds mature in one to 30 years. Commercial paper has no coupon payments. There is only a single final payment due when the term ends. On the other hand, bonds have interest payments that occur semi-annually throughout the loan term.
The maturity period of Commercial paper ranges from 1-364 days.
No, the issue of commercial papers happens only through private placements only.