What is Commercial Paper: Features, Types and How to Invest?

In the money market in India, various financial instruments giving options to the government as well as private corporations to raise funds to meet their business-related requirements. At the same time, such investable instruments give an opportunity for people to invest in such instruments with the flexibility to choose as per their risk appetite and time horizon.

Commercial paper (CP) is one of the investable instruments issued by corporations with a short-term duration, allowing investors to get returns in the short term. Today in this article, we are going to discuss about the commercial paper, who can issue it, what its features are, types, and the pros and cons of commercial paper with few tips how to invest in such instruments.

What Do You Mean by Commercial Paper?

It is a short-term unsecured loan or debt instrument used in the money market to raise funds for the short-term needs of corporations. It is issued in the form of a promissory note to meet the various operational expenses, like inventory purchase or paying off the short-term liabilities.

Introduced in 1990, India’s commercial preps gives an alternative short loan option to corporates to raise funds at low cost with short–term duration. It is regulated by the RBI and usually purchased by individuals, institutional investors, banks and corporate bodies.

Who Issues Commercial Paper?

The commercial paper is issued at a discount by the large corporations, financial institutions and primary dealers looking to meet the short-term financial needs through unsecured loans. High-creditworthy corporations or companies issue it to raise short-term working capital funds.

On the other hand, the financial institutions like banks, finance companies, which are the major players in issues of such instruments, also issue them to meet the expenses of their daily operations. And primary dealers who are specialised and authorised by the government can also issue the same.

Features of Commercial Paper in India

Unsecured Instrument: This short-term financial instrument is not backed by any collateral security, which means it is an unsecured loan and issued on the creditworthiness of the issuer.
Maturity Period: The maturity period of commercial paper is between 7 days and one year, depending on the issuer. However, most of them have a 270-day period maturity date.
Minimum Amount: The minimum amount you can invest in commercial paper is Rs 5 lakh and multiples thereof. However, it is also issued in high denominations (Rs 1 crore or more), hence it is more suitable and affordable for institutional investors.
Issue Price: It is generally issued at a discount and redeemed at par, and the difference is calculated as the returns on such investments.
Dematerialised: As per the guidelines by RBI, all commercial papers are issued in dematerialised form, or you can say in electronic form, to make it easy for transactions and redemption.
Issued By: The corporates, including financial institutions and big companies with a specific minimum tangible net worth and a credit rating from top rating agencies like ICRA or CRISIL, can only issue this.
Liquidity Condition: It is traded in the secondary market, making it highly liquid in terms of sale and purchase by the investors before the date of maturity.

Commercial Paper Example

Suppose a company X is looking to raise low-cost funds of around Rs 75 lakh to meet its short-term financial needs, such as for purchasing inventory for the company. The company can choose from various types of commercial paper with different maturity periods.

The company can issue the commercial paper at a discount of Rs 72 lakh with a maturity date of 90 days, with the value of Rs 75 lakh, this gives an opportunity for the investor to earn good returns by investing in such type short term financial instruments.

Types of Commercial Paper

Different types of commercial papers are issued in the money market with different attributes, giving varied options for the issuer as well as investors to choose the right one as per their needs. Let’s find out what the different types of commercial paper are popular in the market.

Promissory Notes: It is a simple and one of the most common types of commercial paper issued with the promise to pay a certain amount with interest on a specific date. It is used for short-term borrowing for business transactions, carrying all the legal obligations.
Draft CP: It is issued to meet the instant cash requirements or trade finance. The person who issues the draft is called the drawer, and the buyer of the draft is known as the drawee. It is suitable for commercial dealings involving high-value items.
Letters of Credit: As the name suggests, this type of CP is issued by banks with the guarantee to ensure the seller will get the payment from the buyer till the terms of the agreement are fulfilled. It can also be issued with the guaranteed payment of goods or services on the issuer’s behalf.
Secured Commercial Paper: It is an asset-backed commercial paper issued with secured underlying financial assets. It is also called the special purpose vehicle backed with assets, making it a secured commercial paper better than a normal one.
Unsecured Commercial Paper: This is an unsecured commercial paper not backed by any assets or issued without any security.
Financial Commercial Paper: Financial institutions, such as banks or non-banking financial companies, issue this to meet the short-term liquidity needs.
Receivable-Backed Commercial Paper: This type of CP is backed by receivables of the company, like accounts receivable or outstanding invoices, providing the financial security to the investors.
Registered Notes: It is a type of CP that is issued with the recorded name of the ownership in the ledger to ensure the investor to whom it is issued holds the security. This makes the transfer of ownership more transparent, also making tracking easier with protection from missing.

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Advantages and Disadvantages of Commercial Paper

The commercial paper gives a wonderful opportunity to investors as well as issuers to take advantage of short-term borrowings. However, before you invest or consider buying this, you need to know its limitations or disadvantages and advantages for the stakeholders.

Advantages of Commercial Paper

Low-cost Financing: This is a low-cost borrowing that can be issued at cheaper rates with full regulatory terms and conditions.
High Liquidity: It is a very liquid financial instrument available for trading in the secondary market, giving an option to liquidate its investment and exit anytime.
High Yield: Compared to stocks, bonds and other traditional investment instruments, the returns from commercial paper are high, making it a high-yield financial instrument.
Quick Financing: It is a good option for companies to raise funds in a short period.
Collateral Not Required: The best part of CP is that it is an unsecured loan that doesn’t need any collateral security while raising the funds.

Disadvantages of Commercial Paper

Credit Risk: It is an unsecured instrument, issued on the creditworthiness of the issuer, it is a high-risk investment if the issuer defaults to return.
Duration: The maturity period is very short, making it difficult for the investor to keep reinvesting in similar assets to get good returns in the long term.
Limited Access for Retail Investors: It is suitable for institutional investors, as it requires a high minimum amount to invest, and market liquidity is also low.
Restricted for Large Firms: Not suitable for small firms. Due to the high creditworthiness required, only big firms or blue-chip companies with high credit ratings can issue such instruments.
Unsecured Debt: It is a bit backed by any collateral security, making it a high-risk financial instrument suitable only for high-risk-taking investors.
High Denomination: It is issued in large denominations that are not affordable for retail investors to invest like large or institutional investors.

How to Invest in Commercial Paper?

To invest in commercial paper, you have two options: you can directly purchase it either from the issuer or through a broker. However, high-net-worth individuals or institutional investors can purchase directly from the issuing company or through any intermediary.

On the other hand, retail investors can invest through money market brokers or mutual funds. Here, while investing in such commercial papers, you should check the creditworthiness of the issuer, the maturity period and its liquidity and regulatory aspects.

Summing-up

Commercial papers are short-term debt instruments issued by corporations to raise quick funds to meet the working capital needs of their business. It is issued at a discount and redeemed at par, with the maturity period ranging from a few days to one year but 270 days maturity period is more popular, offering a high-yielding investment opportunity for everyone.

It is an unsecured debt instrument not backed by any collateral security issued by only high-credit-rating large companies. The minimum denomination to invest in commercial paper is high, thus high-net-worth individuals and institutional investors prefer to invest in such high-risk instruments.