Because of the short-term nature of commercial paper, many issuers of commercial papers find it challenging to meet the restrictive and demanding eligibility criteria set by investors. The failure to meet these criteria can make it hard for companies to issue new commercial papers or refinance existing issues. Issuers of commercial paper must be able to demonstrate, as part of their pitch, why a particular investor is likely to accept the company’s offering.
What are commercial papers?
Commercial papers are short-term debt instruments issued by reputable companies. These instruments are important to companies that have short-term cash flow requirements and do not want to borrow from banks. Investors are happy to get a decent return compared to banks’ five returns. Issuers of commercial papers must compete for short-term investors.
Issuers of commercial papers should also take care when structuring an issue of commercial paper (CP) because different types of CP have different appeals. Depending on what you want from your CP deal, you may wish to consider one type over another. There are three main types of commercial paper: Standalone CP; Supplemental CP; and Catalytic CP. Let’s take a look at each type in more detail. Before reading further, please read Commercial Paper 101 to give you some background.
Who purchases Commercial Papers? Commercial papers issuers are in most cases financial institutions such as banks, insurance companies, and other finance subsidiaries of large organizations. Merchants, manufacturers, and some structured finance issuers are also active. These are the same companies that purchase commercial papers.
#1. Standalone Commercial Paper
In a standalone issue, issuers of commercial papers sell the entire amount of their commercial paper directly to investors. This issue type makes sense for issuers that intend to use the funds quickly and don’t want to incur the overhead costs associated with issuing bonds or an equity offering. The downside of this approach is that it’s harder to structure an issue to make it appealing to a particular type of investor. Your structure will be dictated in part by the type of investor you’re trying to attract. For example, if you’re issuing commercial paper to fund activities related to your core operations, you may wish to structure the issue to avoid attracting opportunistic investors.
#2. Supplemental Commercial Paper
In a supplemental issue, issuers of commercial papers sell a portion of its commercial paper to investors and use the proceeds to refinance existing commercial paper. This approach can be useful when an issuer’s commercial paper income is sufficient to fund the refinancing of existing paper without selling new commercial paper.
The downside of this approach is that it can create the impression that the issuer is running out of cash and may make it harder to attract an investor who is looking for long-term investment. You may wish to structure the issue to avoid creating this impression. If the issuer has a history of refinancing its commercial paper frequently and in small increments, you may be able to structure the issue to avoid some of these pitfalls.
#3. Catalytic Commercial Paper
A catalytic issue is similar to a supplemental issue, in that issuers of commercial papers sell some of their commercial paper to investors and uses the proceeds to refinance existing commercial paper. The key difference is that the issuer can use the proceeds from the new issue to pay off an existing creditor. For example, an airline that uses a lot of short-term fuel may have a credit facility that requires it to pay off an existing fuel bill upon maturity.
In this scenario, the issuer may refinance its existing commercial paper to pay off the existing fuel bill and then use the money from the new issue to pay off the existing fuel bill. This approach can be useful when an issuer’s commercial paper income is insufficient to fund the refinancing of existing paper. The downside of this approach is that it may create the impression that the issuer is in danger of defaulting on its obligations.
#4.CP with a Co-Issuer
A co-issuers of commercial papers can be either investors or co-issuers that issue commercial paper alongside the primary issuer. An investor or a co-issuer can structure its commercial paper offerings in a way that helps provide liquidity to the issuer. Increasingly, co-issuers find that it makes more sense for them to structure the commercial paper offerings to allow the issuer to use the funds.
Co-issuers can structure their paper this way to help the issuer meet its short-term funding needs. For example, a company that needs to pay off a vendor that is due a large payment soon may issue commercial paper alongside the co-issuer. The co-issuer can refinance the commercial paper and use the proceeds to pay off the vendor. The advantage of this approach is that the issuer does not have to conduct a formal offering, which can be burdensome.
Commercial paper vs treasury bills
Issuers of commercial paper should be aware of alternative investment opportunities for investors. Treasury bills are government-issued debt instruments with maturities not exceeding 12 months. The governments usually set a minimum investment amount ($100 for US Treasury Bills). Treasury bills do not have a fixed rate. The interest rate is determined through bidding and the purchase price is discounted. For example, if the interest to be earned at the end of the period is $10, then investors will pay $990.
Commercial papers on the other hand are issued by private companies (usually AAA-rated) at fixed interest rates. Unlike treasury bills that are bought at a discount, the promise is that investors will receive principal +interest. The interest rate offered is usually higher than treasury bills. This is because investors are exposed to higher risks compared to treasury bills.
Investing in treasury bills is very simple and has tax benefits. They are considered risk-free because they have government backing. Commercial paper interest rates should be higher in order to attract investors away from treasury bills.
Commercial paper vs treasury bonds
Treasury Bonds are government-backed securities that pay fixed interest rates every six months until maturity. Treasury bonds have a maturity period of up to 10 years. At the end of that period, Treasury will pay the investor the par value (the amount you invested in the beginning).
Commercial paper vs bonds
Private companies can issue commercial papers or bonds. Both are debt instruments. Unlike commercial papers that are short-term in nature, bonds have a longer tenor. Bonds are issued to meet the long-term financing needs of a company and carry a higher risk for investors. Investors may earn a fixed interest rate or variable depending on the type of bond preposition.
Commercial paper example
If you are planning to issue a commercial paper, then number crunching is unavoidable. Firstly, you will need to determine the value of the funds you require. Then the costs of racing the funds. You will need to calculate annual commercial paper interest. The formula is as follows: Annual CP Interest = (Discount fee + dealer fee+ backup fee)*365/Usable funds*Days to maturity. But this should worry you. There are many calculators and apps that can help you.
Commercial paper is a flexible funding tool and a popular option for many companies. Issuers should consider how different types of CP might aid their fundraising efforts. By choosing the right structure for your issue, you can maximize the number of investors who are interested in purchasing your paper. For example, the commercial paper may be used in structured finance where a company uses them in short term as a bridge for borrowing in anticipation of a better economic condition (lower interest rates) in the future. At that time, the company can then go for a suitable bank loan.
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