Commercial Paper: A Solution For Short Term Liquidity | srei

Commercial Paper: A Solution For Short Term Liquidity

Commercial paper (CP) is defined as a short term, unsecured, negotiable promissory notes with fixed maturity. For a corporate this type of a short term capital market product is used to raise funds and is issued by rated companies at a discount to face value.

Commercial paper is not backed by collateral and in order to sell it at a reasonable price, firms need to have an excellent credit rating from a recognized rating agency.  All commercial paper issues in India follow the mandate of being rated by at least one of the credit rating agencies. Originally, only the highest credit quality entities had the Commercial paper market available to them. What has made CP viable for entities with low credit ratings these days are innovations such as liquidity programs, credit enhancements and various special legal structures. Commercial Paper usually carries higher interest repayment rates than bonds. It is often cheaper to draw on a commercial paper than on a bank line of credit after a business becomes established and builds a high credit rating.

Corporate issued commercial paper is not the only type of commercial paper available in the market today. Asset backed commercial paper (ABCP) is a way for financial institutions to more efficiently finance their receivables through off-balance sheets. ABCP’s are sold through special purpose vehicles also known as conduits. These conduits have many structures and they pool assets of many entities from various industries. Diversification from multiple sellers of various industries is one of the main goals of such a multi-seller ABCP program. Structured investment vehicle (SIV) is another relatively new structure that issues commercial paper and do not serve the purpose of funding in the traditional sense. Certain Structured investment vehicles capitalize on spread differentials in fixed income securities, earning interest rate arbitrage profits. Some of the asset categories that SIV’s invest in are difficult to value as they are not traded in the open market.  

In addition, other variations of CP have been introduced in the market in recent years, including extended liquidity notes. The maturity of notes in this variation of the commercial paper (also called extendible or structured notes) may extend beyond their original maturity date in the case of a default. The MSF rate was raised from 8.25 per cent to 10.25 per cent this July to curb the volatility in the rupee. As a direct result of such an easing in short term rates companies are shifting from bank borrowings to the commercial paper (CP) market.

Governments have a short term investment approach as far as the commercial paper is concerned. Investments are usually made for funds that are not immediately required and to provide diversification and competitive rates of return. Most governments that purchase CP also follow a ‘buy and hold approach until maturity strategy’.  There have been periods of disruption due to either issuer-specific events or as a result of a broader market wide disruption. This has been the case inspite of an already existing secondary market that can be used for sales prior to maturity.

Market disruptions present investors with another risk of not being able to issue new CP to refinance the maturing commercial paper thus causing the secondary market to disappear. CP is usually backed by bank lines of credit to mitigate this risk.