On Tuesday, the Securities and Exchange Board of India (SEBI) came out with a framework to list commercial papers on stock exchanges to increase the participation of investors in such securities.
Should you consider investing in commercial papers to diversify your portfolio?
What are commercial papers?
Commercial papers are generally issued by institutions to raise funds to meet their short-term funding needs like inventory or accounts payable or to fund the start of a new project. These are short-term, unsecured debt instruments that are issued for periods of less than one year.
Large banks or corporations with high rating generally issue these to meet their short-term borrowing needs.
According to RBI's website, "Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs) are eligible to issue CP" to meet their short-term funding requirements for their operations.
What kind of corporates can issue CP?
As per the information on RBI's website, a corporate can issue commercial papers provided:
- the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs 4 crore
- company has been sanctioned working capital limit by bank/s or all-India financial institution/s; and
- the borrowal account of the company is classified as a Standard Asset by the financing bank/s/ institution/s.
Ratings requirement to issue commercial papers
All eligible participants are required to obtain a credit rating for issuance of CP either from CRISIL or ICRA or CARE or the FITCH Ratings India or such other credit rating agency (CRA) as specified by the RBI for the purpose.
The minimum credit rating is required to be A-2.
Period of maturity
Commercial Papers can be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue. However, the maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid.
These can be issued in denominations of Rs 5 lakh and multiples of it thereof.
Purchasing Commercial Papers
CPs are issued on a single date or in parts on different dates provided that in the latter case, each CP has the same maturity date. Every issue of CP, including renewal, is treated as a fresh issue.
The issuer of the CP is required to raise the total amount proposed within a period of two weeks from the date of issue of such a subscription.
Issuing and Paying Agents (IPA)
Only scheduled banks can act as IPAs to issue commercial papers. At the time of purchase, the investor is required to pay only the discounted value of the CP by means of a crossed account payee cheque to the account of the issuer through IPA.
On maturity of CP, when held in demat form, the holder of the CP will have to get it redeemed through the depository and receive payment from the IPA.
Who can invest in CP?
Individuals, banking companies, other corporate bodies (registered or incorporated in India) and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs) etc. can invest in CPs. However, investment by FIIs would be within the limits set for them by SEBI.
Should you invest in commercial papers?
The regulatory requirement to obtain an A-2 rating to issue commercial papers is due to the fact that these instruments are unsecured, that is, these are not backed by any collateral to assure the repayment.
With a good rating from a recognised rating agency, a corporate or bank can issue commercial papers at a reasonable rate. These are generally sold at a discount from the face value. The longer the maturity, the higher the interest rate.
Interest rates fluctuate in accordance with market conditions and are generally lower than bank rates but higher than bonds.
Commercial papers are actively traded on the secondary markets for those who wish to purchase them after the subscription period for the issue closes or sell them before maturity.
Whether or not to invest in commercial papers depends on your risk appetite, investment capacity and understanding of the trade markets. If you are a conservative investor who does not have the time to track the markets and research on the company issuing the commercial papers, it is better to stick to bank deposits which can be opted for varied tenures and at guaranteed interest rates.
For the risk-taker, commercial papers will help diversify the fixed income investments you make, especially if the interest offered is high amid falling bank interest rates.
However, it is important to understand that these are unsecured deposits and the repayment of the principal invested along with the interest depends on the financial strength of the issuer.