What are commercial papers? Types and benefits explained Daily Journal

Published on: September 25, 2024

When companies need a fast, efficient, and low-cost way to raise money, they often choose commercial paper. Commercial paper is an efficient and cost-effective short-term, unsecured debt instrument for businesses. They are fast, flexible, and are generally issued by well-established companies to cover payroll, inventory, or other short-term liabilities.

But what exactly is commercial paper, and why do companies choose it?

What are commercial papers?

Commercial paper is a short-term financial instrument used by businesses to meet immediate financial needs, such as covering daily operating expenses. It was introduced in India in 1990 to provide companies with an alternative source of raising funds, especially for companies with high credit ratings.

Companies with strong credit ratings are able to issue commercial paper, as investors place great confidence in the financial stability of the issuer. Since commercial paper is a form of unsecured financing, the issuing company does not offer any assets as collateral to guarantee payment, making the financial health of the issuer an important factor for investors.

It usually must be repaid to the investor within 270 days, with many companies choosing to repay it in 15 to 45 days. There are two types of commercial papers: bearer bonds, which are physical documents, and registered notes, which are tracked electronically under the investor’s name.

Advantages of commercial paper

Here are some features of commercial paper that make it a popular choice for both issuers and investors:

1. Low cost

It is generally cheaper for companies to issue commercial paper rather than borrow money in other ways, such as bonds, because there are fewer regulations and shorter time frames.

2. High returns

Interest rates on commercial paper are often higher than what you would get from savings accounts, providing investors with a much better investment option.

3. Flexibility

Companies can use funds from commercial paper for various purposes, including financing working capital, refinancing existing debt, or investing in new projects.

4. Low risk

Commercial paper is mostly issued by financially stable companies with good credit ratings. This reduces the risks to which investors are exposed compared to other types of investments.

5. Tax advantages

In some cases, interest earned on commercial paper may qualify for preferential tax benefits that investors may prefer.

6. Liquidity

Investors can easily sell their commercial paper before it matures, allowing them to access their money quickly if needed.

7. Ease of access

Investors can often purchase commercial paper directly from brokers or issuers, making it easier to invest.

8. Regulatory oversight

They are vetted by the Securities and Exchange Commission (SEC), providing an additional layer of protection for investors and issuers alike.

9. Unsecured debts

Commercial paper is considered unsecured debt, because it is not backed by collateral. Investors base their decisions on the financial health of the issuing company and its ability to generate income.

10. Diversification

Adding commercial paper to an investment portfolio can help spread risk, since their performance does not often follow stocks or bonds closely.

Types of commercial papers

Each type of commercial paper has unique benefits and risks, and investors can choose according to their specific financial goals and risk tolerance.

The main types of commercial papers are as follows:

1. Drafts

Bills of exchange, or bills of exchange, are formal orders in which the drawer directs the drawee to pay a certain amount to the beneficiary. These tools are commonly used as a means of payment or money transfer, especially in international business transactions.

2. Bills of exchange

Promissory notes are formal agreements in which the issuer commits to pay a specified amount to the beneficiary on a specified date. These legally binding documents regulate loans or debts between individuals, companies, or financial institutions.

3. Commercial papers backed by receivables

This type of commercial paper is secured by accounts receivable, which may include invoices for goods or services already provided.

4. Asset-Backed Commercial Paper (ABCP)

Asset-backed commercial paper is a type of commercial paper secured by a pool of underlying assets such as receivables or loans. This provides security to investors, as assets can be sold to pay off debts if the issuer defaults.

5. Certificates of deposit (CDs)

Certificates of deposit (CDs) are fixed-term deposits made by banks and financial institutions. Investors put in a specific amount of money for a specific duration and earn interest at a predetermined rate. CDs are viewed as low-risk investments because they provide guaranteed returns and guarantee repayment of the initial deposit at maturity.

6. Letter of Credit (LOC)

A letter of credit is a document from a bank that guarantees payment for goods or services, even if the buyer cannot pay. It is commonly used in international trade to ensure sellers get their money.

7. Organized notes

Structured bonds are complex investments linked to the performance of other assets such as stocks or bonds. The return investors receive depends on how those underlying assets perform.

8. Recorded notes

These papers represent ownership of the commercial papers and are officially registered in the buyer’s name. This makes it safer and easier to track.

Advantages and disadvantages of commercial papers

Here are some advantages and disadvantages of commercial papers

Advantages of commercial paper:

1. Low Risk: Commercial paper is generally issued by companies with strong credit ratings, making it a low-risk investment for those looking to invest in a financially stable business.
2. Short-Term Investment Option: Commercial paper has a maturity period of less than 270 days, making it a good option for investors who prefer short-term investments. This allows investors to access their capital relatively quickly.
3. High Liquidity: Because they are traded on the secondary market, investors can easily buy or sell commercial paper, providing them with flexibility if they need to convert their investments into cash.

Disadvantages of commercial papers:

1. Unsecured Debt: Commercial paper does not require any collateral to be pledged, which means that if the issuing company defaults, investors will likely lose their investment.

2. Lower returns: Commercial paper returns are usually lower compared to other types of investments, such as stocks or corporate bonds. This makes it less attractive to investors looking for high returns.

3. Market Dependence: The cost of commercial paper is affected by general market conditions. During periods of financial instability, companies may experience higher borrowing costs when using this financing option.

Commercial paper versus bonds

When companies need to borrow money, they can do so by offering commercial paper or bonds. Let’s take a look at the difference between commercial papers and bonds.

feature	Commercial paper	Bonds
very	Short-term loans for companies	Long-term borrowing by companies or governments
Maturation period	Up to 270 days	From 1 to 30+ years
Guarantees	Not guaranteed (no guarantees)	They are usually secured by collateral or backed by collateral
Risk level	Low risk (if issued by highly rated companies)	Reduced risk due to guarantees or guarantees
Return(s)	Higher returns than bonds for short-term investors	Lower returns but provides stable, long-term income
Liquidity	High liquidity (shorter duration, easy to sell)	Low liquidity (longer duration, difficulty exiting early)
Investor file	Ideal for investors looking for quick and higher returns	Ideal for investors looking for stable, long-term income

conclusion

From an investment perspective, commercial paper provides companies with a flexible and cost-effective option to raise short-term funds without the need for collateral. Its unsecured structure attracts investors looking for relatively low-risk, short-term returns while providing companies with quick access to capital to support their immediate financial goals. For investors, it can serve as a reliable liquid asset with competitive interest rates compared to other short-term investments.

Frequently asked questions

Who can issue commercial papers?

Commercial paper can only be issued by financially stable and creditworthy companies, financial institutions, and certain government agencies. These issuers must have a strong credit rating because the debt is unsecured, meaning it is not backed by collateral.

What happens when commercial paper matures?

Upon maturity, the issuing company must pay the nominal value of the commercial paper to the investor. Companies may issue new commercial paper to roll over debt or pay it off using internal funds or other financing methods.

Is commercial paper a good choice for all companies?

No, commercial paper is generally suitable for large, creditworthy companies. Small businesses or those without a strong credit rating may not be eligible to issue commercial paper and will need to explore alternative financing options such as Business loans.

How are commercial papers traded?

Money market commercial paper is typically traded through over-the-counter (OTC) transactions between institutional investors, such as banks, mutual funds, and pension funds. It is not generally traded on public exchanges.

What is the maturity period of commercial papers?

The maturity period of commercial paper ranges from 1 to 270 days. The issuer decides the term based on its immediate financing needs, and investors choose the paper that best matches their investment strategy.