What is commercial paper – Commercial paper is a short-term, unsecured promissory note issued by corporations, financial institutions, and other large entities to meet their short-term financing needs. It is typically issued at a discount to its face value and matures within 270 days or less, usually ranging from a few days to a few months.
It serves as a convenient way for companies to raise funds quickly for working capital, accounts payable, and other short-term liabilities.
It is considered a low-risk investment instrument since it is typically issued by entities with strong credit ratings, making it an attractive investment for institutional investors, money market funds, and other entities seeking short-term investments.
Investors earn interest through the difference between the discounted purchase price and the face value paid at maturity.
The interest rate on is generally lower than other forms of short-term borrowing, such as bank loans, making it a cost-effective financing option for issuers.
This is typically sold through dealers in the open market and is usually issued in large denominations, such as $100,000 or more, making it more accessible to institutional investors.
However, there are also programs that allow smaller investors to participate by purchasing through money market funds or other investment vehicles.
Characteristics and Features of commercial paper
It’s a short-term, unsecured promissory note issued by corporations, financial institutions, and other eligible entities to raise funds for their short-term financing needs.
It is a widely used instrument in the money market due to its various characteristics and features.
Here are some key characteristics and features:
Short-Term Maturity: It has a short-term maturity, typically ranging from a few days to 270 days, with most issuances having a maturity of 30 to 90 days. This makes it an attractive option for entities seeking temporary financing solutions.
Unsecured: It’s is an unsecured instrument, meaning it is not backed by any specific collateral. The creditworthiness of the issuing entity and its ability to repay the debt are crucial factors in determining the interest rate and its market acceptance.
Issued at Discount: Instrument is typically issued at a discount to its face value, which means that investors purchase the paper at a price lower than its nominal value. The difference between the purchase price and the face value represents the interest earned by the investor.
Highly Liquid: Commercial paper is highly liquid in the secondary market, allowing investors to buy and sell these instruments before their maturity. This liquidity makes it an attractive investment option for money market funds, institutional investors, and other market participants.
Large Denominations: It’s usually issued in large denominations, often starting at $100,000 or more. This feature makes it more accessible to institutional investors and corporations rather than individual retail investors.
Credit Rating: Issuers often obtain credit ratings from rating agencies to provide potential investors with an assessment of the creditworthiness and risk associated with the paper. Higher credit ratings can lower the cost of borrowing for the issuer.
Issued through Dealers: Instrument is typically issued through dealers, which can be banks or other financial institutions that have established relationships with issuers. Dealers help in marketing the paper to potential investors and assist with the distribution process.
Flexible Terms: Commercial paper offers flexibility in terms of the amount issued, maturity dates, and interest rates. The terms are negotiated between the issuer and the investor, allowing for customization based on the needs and preferences of both parties.
Regulation: Issuers must comply with regulations set by the Securities and Exchange Commission (SEC) in the United States and other relevant regulatory bodies in different jurisdictions. These regulations aim to protect investors and ensure transparency in the commercial paper market.
Market Size and Depth: The market is vast and plays a significant role in the overall money market. It provides short-term funding for corporations and financial institutions, allowing them to meet their working capital requirements efficiently.
Types of Commercial Paper
There are various types based on the issuer and the underlying purpose.
Here are some common types:
1)Treasury Bills (T-Bills): T-Bills are short-term debt instruments issued by the government to fund its short-term cash requirements.
They are considered one of the safest forms since they are backed by the full faith and credit of the government.
2) Banker’s Acceptance: Banker’s acceptances are financial instruments that arise from commercial transactions and are guaranteed by a bank. They are commonly used in international trade to facilitate the purchase or sale of goods. Banker’s acceptances have a specific maturity date and are often sold at a discount.
3) Certificate of Deposit (CD): CDs are time deposits issued by banks and financial institutions. They have a fixed maturity date and offer a predetermined interest rate.
CDs are generally considered to be low-risk investments, and their interest rates are typically higher than regular savings accounts.
4) Asset-Backed Commercial Paper (ABCP): ABCP is a type that is backed by a pool of underlying assets such as mortgages, auto loans, or credit card receivables. These assets serve as collateral and provide an additional layer of security to investors.
ABCP is typically issued by special purpose vehicles (SPVs) and is often used to finance consumer loans and other asset-backed securities.
5) Commercial Bank Paper: Commercial banks may issue their commercial paper to raise short-term funds. This type is backed by the bank’s general creditworthiness and is typically issued to institutional investors.
6) Finance Company Paper: Finance companies, which specialize in providing loans and financing, may issue commercial paper to fund their lending activities. Instrument issued by finance companies is based on their creditworthiness and is usually sold to institutional investors.
7) Industrial Paper: Industrial companies may issue commercial paper to meet their short-term funding needs. These issuances are based on the creditworthiness of the issuing company and are often purchased by institutional investors.
The issuance process of commercial paper in Nigeria generally involves several steps and the involvement of various parties.
Here is a simplified overview of the commercial paper issuance process in Nigeria:
Eligibility: The issuing company must meet certain criteria to be eligible for issuing commercial paper. These criteria may include financial stability, a good credit rating, and compliance with relevant regulations.
Arrangement with Issuing House: The issuing company engages the services of an issuing house, which is a registered financial institution licensed to carry out capital market activities. The issuing house assists in structuring the program and facilitating the issuance process.
Program Approval: The issuing company and the issuing house submit a formal application to the Securities and Exchange Commission (SEC) for approval.
The application includes details such as the proposed amount to be raised, maturity periods, interest rates, and other relevant information.
Due Diligence: The SEC conducts a thorough review of the application, including the financial position and creditworthiness of the issuing company.
The SEC ensures compliance with the relevant regulations and may request additional information or clarification during the due diligence process.
Issuance Documentation: Once the commercial paper program is approved, the issuing house prepares the necessary documentation, including the information memorandum, offering circular, and subscription forms.
These documents contain key details about the offering, such as terms, conditions, and risks involved.
Rating and Marketing: The issuing company may seek a credit rating from a recognized credit rating agency. The rating agency evaluates the creditworthiness of the issuing company and assigns a rating accordingly.
The issuing house then markets the commercial paper to potential investors, including institutional investors and high-net-worth individuals.
Subscription and Allotment: Interested investors submit their subscription forms indicating their desired investment amount.
The issuing house receives and reviews the subscription forms and determines the allotment based on available funds and the terms of the offering.
Payment and Issuance: Investors whose subscriptions are successful are required to make payment for the allotted.
Once the payment is received, the commercial paper is issued to the investors in the form of a certificate or through electronic book-entry systems.
Trading and Secondary Market: After issuance, it may be listed on a recognized securities exchange, such as the Nigerian Stock Exchange (NSE).
This allows investors to trade commercial paper in the secondary market, providing liquidity and flexibility.
Repayment: As commercial papers have a specified maturity period, the issuing company repays the principal amount to the investors upon maturity. Interest payments may also be made periodically according to the terms.
What is commercial paper in simple words?
Commercial paper is a form of unsecured, short-term debt. It’s commonly issued by companies to finance their payrolls, payables, inventories, and other short-term liabilities. Maturities on commercial paper range from one to 270 days, with an average of around 30 days.
What is commercial paper in Nigeria?
Commercial Papers (CPs) are short-term debt obligations of corporations. They can be issued for tenors of up to 270 days in the Nigerian financial markets. Like Treasury Bills, they are typically issued at a discount and redeemed at par (face value amount) upon maturity.
What are the objectives?
The main objectives of the commercial paper include:
Short-term liquidity: The primary purpose of commercial paper is to provide quick and convenient access to short-term funds. It allows companies to address temporary cash flow needs, such as funding payroll, managing inventory, or financing accounts receivable.
Cost-effective financing: By issuing commercial paper, organizations can typically obtain funds at a lower cost compared to other sources of short-term financing, such as bank loans.
This is because commercial paper usually carries a lower interest rate or discount rate, reflecting the creditworthiness of the issuing entity.
Diversification of funding sources: It enables companies to diversify their sources of funding beyond traditional bank loans.
It allows them to tap into the broader money markets and attract investors, including individuals, money market funds, and institutional investors seeking short-term investments.
Flexibility and convenience: Issuing commercial paper provides flexibility in terms of maturity and funding amounts. Companies can tailor the issuance to their specific needs, choosing the maturity period that aligns with their cash flow requirements and issuing the desired amount of commercial paper.
Building investor relationships: Commercial paper issuance can help establish and strengthen relationships with institutional investors and other market participants. By regularly issuing commercial paper, companies can demonstrate their creditworthiness and reliability, potentially attracting more investors in the future.
Enhancement of creditworthiness: Consistently issuing and successfully repaying commercial paper can enhance a company’s credit profile.
It can help improve its credit rating, making it easier to access other forms of financing, negotiate favorable terms, and attract investors at competitive rates.
Bridge to long-term financing: Commercial paper can serve as a temporary solution while companies arrange for more permanent or long-term financing options.
It provides an interim source of funds until a company secures long-term loans, issues bonds, or raises capital through other means.
Who issues commercial paper in Nigeria?
In Nigeria, various entities, including corporations, banks, and government agencies, may issue commercial papers to meet their financing requirements.
These issuers may include Nigerian companies, multinational corporations with a presence in Nigeria, commercial banks, and even state or federal government bodies.
What is the difference between a bill of exchange and commercial paper?
A commercial bill is an instrument that helps companies to get advance payment for the invoices they raise after making sales to their customers.
Commercial paper is used by banks to meet their short-term obligations, while commercial bills help companies to get money in advance, for sales they make.
Commercial paper vs treasury bill
Commercial paper and treasury bills are both short-term debt instruments issued by different entities and used for different purposes. Here’s a comparison of commercial paper and treasury bills:
Issuer: Commercial paper is issued by corporations and financial institutions with high creditworthiness. These entities use commercial paper to meet short-term funding needs.
Maturity: Commercial paper usually has a maturity of 1 to 270 days, although the most common maturities range from 30 to 270 days.
Market: It’s traded in the commercial paper market, which is an over-the-counter market where institutional investors, such as money market funds, purchase these instruments.
Interest Rate: The interest rate on commercial paper is typically higher than treasury bills because it reflects the credit risk associated with the issuing entity. The rate is usually quoted as a discount to face value.
Risk: Commercial paper carries credit risk, meaning there is a possibility of default if the issuing company faces financial difficulties.
Treasury Bills (T-bills):
Issuer: Treasury bills are issued by the government, specifically the U.S. Department of the Treasury. They are used to finance the government’s short-term borrowing needs.
Maturity: Treasury bills have fixed maturities of 4, 13, 26, or 52 weeks. They are also issued as 3-month, 6-month, and 1-year T-bills.
Market: Treasury bills are traded in the secondary market, where individual investors, institutional investors, and government entities can buy and sell them.
Interest Rate: The interest rate on treasury bills is typically lower than commercial paper because they are considered to be very low-risk investments. The interest is earned through the difference between the purchase price and the face value of the bill.
Risk: Treasury bills are considered to be risk-free since they are backed by the full faith and credit of the government. The risk of default is extremely low.
The commercial paper serves as a crucial component of the money market, providing short-term financing options for corporations and institutions while offering a relatively safe and liquid investment option for investors.