What is Commercial Paper? Meaning, Types, Advantages & Examples
Debt is a liability, but did you know that debt can be an asset too? Large corporates, NBFCs, and Financial institutions participate in long-term and short-term debt markets for borrowing funds. One such instrument is Commercial Papers.
Financial Institutions and corporations issue commercial papers to finance their working capital needs, such as inventories, payables, salaries, etc. It provides a cost-effective way of raising funds for 7 days upto a year and can be issued in a denomination of ₹ 5 lakhs or multiples thereof.
In this article, you’ll check the meaning and definition of commercial papers, their types, example, features, advantages, who issues them, maturity period, interest rates, and minimum amount.
What is a Commercial Paper?
Commercial papers are short-term debt instruments companies issue to meet short-term financing needs, like working capital requirements, including salaries, inventories, etc. These are unsecured securities.
It is issued as a promissory note with a high denomination and exchanged between financial entities and primary dealers. The maturity period of a commercial paper is between 7 days upto a year.
An example is a commercial paper issued by SBI or a corporate firm to meet their short-term funds’ requirements.
Commercial Paper in India
The Commercial Paper was introduced in India in 1990; its launch symbolised financial reforms in India. The primary aim of allowing commercial paper in the market was to enable corporates with good credit ratings to have an additional channel for borrowings apart from other debt instruments. Through this instrument, RBI also provided investors with another reliable mode of fixed-income debt investment. Subsequently, RBI allowed all financial institutions and primary dealers to issue commercial paper and meet their capital needs, e.g. project costs and other short-term financial obligations.
Features of Commercial Paper
- It is a short-term debt instrument with a fixed maturity period.
- It usually is an unsecured loan, which means the borrower is not required to provide any collateral for the loan. The loan is given based on the borrower’s financial credibility and rating, e.g. company’s cash reserves, current debt, liquidity, profits, and overall revenues.
- Commercial Paper is a promissory note. The issuer promises to pay the subscriber a fixed amount at a specified time.
- It is issued at a discount to the face value and can be issued as an interest-bearing instrument.
Who can Issue a Commercial Paper in India?
The RBI has published clear guidelines on entities that can issue CP (Commercial Paper) in India. As per these guidelines, primary dealers, \, highly rated corporate borrowers, and Indian Financial Institutions have the permission to issue CP and raise funds. Thus, a commercial paper can be issued by the following:
- Corporate borrowers
- Non-Banking Financial Companies (NBFCs)
- All India Financial Institutions (AIFIs)
- Government Institutions
- Registered Trusts
- Other permitted entities who have a net worth of over Rs. 100 crores or above.
There are specific criteria that a company must fulfil to raise funds through CP:
- Companies, including Non-Banking Finance Companies (NBFCs) and All India Financial Institutions (AIFIs), are eligible to issue CPs subject to the condition that any fund-based facility availed of from bank(s) and/or financial institutions is classified as a standard asset by all financing banks/institutions at the time of issue.
- Other entities like co-operative societies/unions, government entities, trusts, limited liability partnerships and any other body corporate having presence in India with a net worth of 100 crore or higher.
- RBI clearly defines the rating required for any participant to issue a commercial paper. All participants must obtain a credit rating from CRISIL, ICRA or CARE. The rating must be a minimum P-2 from CRISIL or equivalent and should be obtained closer to the time of issuing commercial paper.
Types of Commercial Paper
- Draft: A draft is a written order given by one person to another to pay a fixed sum to a third party on a given date; it involves three parties.
- Cheque: Cheque is another basic type of commercial paper. It is a draft drawn at a bank, and the bank is obligated to make payment when presented with the same.
- Note: A note is a promise to pay a certain amount to a party on a specified date in the future or as demanded. It is also known as a promissory note.
- Certificate of Deposit: A certificate of deposit is an example of commercial paper issued by a bank that certifies that it has received money from the investor and agrees to repay at a given time.
- Based on Security
- Secured Commercial Papers: These are the type of CPs that are backed by collateral. These are structured so that the investor can claim the provided collateral if the issuer defaults.
- Unsecured Commercial Papers: Also known as traditional commercial papers, these are issued without any collateral. They have credit risk, and investors are exposed to the possibility of default.
Advantages of Investing in Commercial Paper
- Cost: It is cheaper than other debt instruments since it is available only to entities with a good credit rating. The cost to the borrower is lower than the cost of a commercial loan.
- No Collateral: It is an unsecured loan and requires no collateral. The borrower need not furnish any document or paperwork required for collateralised bank loans. The time taken to secure funds through a CP is significantly less.
- Liquidity: It offers high liquidity and flexible maturity terms, thus making it an attractive investment for issuers. It is also more credible than other investments owing to the good creditworthiness of the borrower.
Disadvantages of Investing in Commercial Paper
- Accessibility: Commercial papers can only be issued by firms with a higher net worth and credit rating. Also, the minimum ticket size is ₹ 5 lakhs, making it inaccessible to retail investors.
- Interest Rate Risk: Since the rate of interest is fixed, a hike in interest rate in between your investment term can make it a deal of loss for you.
- Lack of Transparency: Only a limited set of information about the issuer is available for the investor compared to publicly listed securities.
The role and responsibilities
When RBI introduced commercial paper for companies to raise funds, it also stipulated rules for all the entities involved:
RBI has laid regulations for the issuers. Any violations of these guidelines can result in penal action and even debarment from issuing commercial papers.
Financing banking company
When a financing banking company receives a proposal for the issuance of commercial paper, they are required to thoroughly scrutinise the application as per the eligibility conditions for issuing the debt instrument. The proposal is approved only after the company passes the scrutiny. After the Commercial Paper is issued, the financing banking company must reduce the working capital limit of the corporate borrower and adjust the amount raised.
The Issuing and Paying Agent (IPA) must verify all the documents submitted by the issuer, e.g. Board Resolution, Credit Rating approval, financial records, etc. before the commercial paper is issued. After the scrutiny, IPA gives a certificate to go ahead.
Only scheduled Banks can act as an IPA. This is to ensure that the guidelines prescribed are diligently followed by issuers and the object of investor protection is not diluted in any manner.
If the CP is proposed to be listed, it shall be mentioned in the letter of offer. The issuer shall be responsible for listing the same and also will comply with SEBI guidelines in this regard.
The Credit Rating agencies must comply with SEBI guidelines for using ratings for money market instruments. The agencies must specify the next rating review period and monitor the issuer’s current credentials. Any misconduct needs to be reported to IPA to reduce the rating.
Commercial Papers have played an essential role in the economy. Companies today require funds to finance their growth and expansion. Commercial Paper is a potent tool for corporates to raise funds easily, quickly and at a lower cost. It is a safe and credible debt instrument for issuers and you, the investor.
FAQs about Commercial Paper
What is the mode of redemption for CP?
Commercial Papers are redeemed at maturity, and payment is made to investors through the designated IPA (Issuing and Paying Agent).
Who can invest in CP?
All Indian residents can invest in Commercial Paper; non-residents can invest as per FEMA regulations.
What are the interest rates?
The interest rate for a CP issued for 3 months is around 7.75%, and for a 1-year CP, interest rates are as high as 8.25%.
How to calculate the yield on Commercial Papers?
The formulae for calculating the yield of commercial paper are as follows:
Yield = [(Face Value – Sale Price)/Sale Price] * (360/Maturity Period) * 100