COMMERCIAL PAPER

COMMERCIAL PAPER      

 

Commercial paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. It is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.

Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.

A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months (270 days), making it a very cost-effective means of financing. The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.

There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market. The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies.

Commercial paper is a lower cost alternative to a line of credit with a bank. Once a business becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a "backup". Banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, in some cases companies in serious trouble may not be able to repay the loan resulting in a loss for the banks.

Advantage of commercial paper:

·         High credit ratings fetch a lower cost of capital.

·         Wide ranges of maturity provide more flexibility.

·         It does not create any lien on asset of the company.

·         Tradability of Commercial Paper provides investors with exit options.

Disadvantages of commercial paper:

·         Its usage is limited to only blue chip companies.

·         Issuances of Commercial Paper bring down the bank credit limits.

·         A high degree of control is exercised on issue of Commercial Paper.

·         Stand-by credit may become necessary

Like Treasury Bills, yields on commercial paper are quoted on a discount basis—the discount return to commercial paper holders is the annualized percentage difference between the price paid for the paper and the par value using a 360-day year.

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Posted in: COMMERCIAL PAPER