A commercial paper is a secured or an unsecured discounted promissory note that is issued by blue chip companies (both financial and non financial companies) to raise short term funds.
The commercial paper is more preferred to bank loans because it can be acquired at lower costs and it doesn’t require collateral hence beneficial to the issuers. In addition, these promissory notes offer better returns compared to the treasury bills thus being attractive to the investors.
“There are basically three types of commercial papers depending on the characteristics of the issuer. They include financial papers, industrial papers and asset backed papers” (Persie 66). The financial papers are issued by large banks that are in need of these funds to finance their loans that are a major source of income.
However, it’s worth noting that such loans are usually issued at high interest rates so that these banks are able to pay an attractive interest to the commercial paper holders. The industrial papers are issued by industrial companies that are in need of finance to supplement their working capital, current transactions and at times to fund their projects though not on permanent basis.
On the other hand, asset backed papers are issued by more risky entities (small banks, insurance companies and stock brokerage firms that are new in the market) where they pledge some of their assets to serve as collateral thus securing the funds of the investors. The collateral in this case could be trade receivables that the company can estimate accurately through experience and thus are payable within the period of the commercial paper.
Moreover, there are limitations to the issuance of commercial papers in that the issuer should meet certain criteria. Firstly, the paper should be issued for less than 270 days, secondly, the funds raised as a result of its issuance are supposed to be used to finance current transactions and projects but on temporal basis and finally, the commercial papers should be in the denominations $ 100,000 so that the general public can’t easily purchase them.
Besides, the entities that can issue the paper are the blue chip companies (large banks, foreign and industrial companies) of good reputation. Examples include General Motors and Ford Motor companies. These entities are able to issue the commercial paper without security and still be accepted by the customers because they are less risky and most of them have been in existence for many years.
The major investors in these commercial papers include companies that deal in mutual funds and large commercial bank holdings that have trust departments. Others include insurance companies, private pension schemes and the general public who can only access these papers via Money Market Mutual Funds that collect and invest a pool of funds from individual investors.
In case an entity wants to issue a commercial paper, it can sell it to a dealer who helps in reselling it to the investors. When the dealer verifies that a bank has received the money on its behalf, it provides the investor with a commercial paper. When the paper matures, the investor has to present the paper to the issuer so that it receives the amount invested with an interest.
It is worth noting that, if the commercial paper issued is a discounted note, then the investor is supposed to pay an amount less than the face value of the note and in this case the interest is implied. On maturity, the issuer of the note pays the investor the face value of the note and the interest is the difference between the face value and the amount initially paid by the investor. However, if the investor is issued with an interest bearing note, then it pays the face value of the note and gets the commercial paper but when the note matures the issuer pays the investor the face value of the note plus an interest.
In addition, different parties have roles and responsibilities to play. To start with, the issuer ensures that the guidelines of the Securities Act have been followed to the letter while issuing these notes. The Issuing and Paying Agent (IPA) on the other hand should ensure that the regulatory requirements regarding exemptions of short term securities from registration have been met.
The IPA also checks whether the issuer has issued a prospectus describing its status and need for finance. In case the issuer defaults, it’s the responsibility of the IPA to inform the investors of such issues. Finally, a registered Credit Rating Agency (CRA) should ensure that it has provided the company that intends to issue a commercial paper with its credit rating.
The issue of a commercial paper as a short term means of raising cash has various advantages over other alternatives. It’s a quick and cost effective way of raising working capital that serves to facilitate daily operations of a company. Besides since its returns are relatively stable, it’s usually the best way for the company to take the advantage of short term interest fluctuations in the market.
Moreover, the investors have the option to quit the investment making it one of the most flexible means of raising funds. If the commercial paper is given good rating, then the cost of capital for the company is reduced significantly because that means that they have less risk and hence the investors will be willing to accept a relatively lower interest rate. Besides, they are cheaper than a bank loan as they don’t necessarily require collateral of which at times risks being auctioned if the borrower defaults payment hence, some commercial papers are unsecured and thus do not create any lien on the assets of the company. The commercial paper has a wide range of maturities that fit the needs of the investors and in addition, they are exempt from federal Securities and Exchange Commission (SEC) and State securities registration requirements.
However, commercial papers have the some disadvantages in the sense that they are restricted only for a few selected blue chip and profitable companies which are also required to issue these notes in denominations of $ 100,000 which small firms can’t match. Also by issuing a commercial paper, the credit available from the banks may get reduced.
As far as the commercial paper in the US market is concerned, there are a number of issuers involving Coca Cola Company, General Motors usually termed as GM, Bank of America and Merrill Lynch Company. GM is a company that deals with the manufacture of motor vehicles and has ventured into markets in about 157 countries across the world.
It manufactures different vehicle designs and this characteristic of GM has enabled it to produce customer tailored vehicles and has given it a good reputation over time. However, in the late 2000s the company got hit by the global economic crunch that affected the US market too. GM experienced a serious financial and corporate culture crisis. This situation almost brought the company to a standstill “prompting the intervention of both Bush and Obama administrations that proposed bailouts of $13.4 billion and $ 39 billion respectively so that they could protect jobs of thousands of employees of the entity and its huge market base” (Brady).
In October 2011, Standard & Poor’s a credit rating company rated GM a notch higher from BB- to BB+ and this was highly attributed to its strong cash flow and a good reputation that it gained from its performance.
Hence, General Motors may raise money through issuing a commercial paper to finance its customers and dealers who purchase its products and leases its assets. This approach enables the company to retain its customers over a long time.
The other company is the Merrill Lynch an investment bank that is subsidiary to the Bank of America Corporation that is basically a commercial bank. “The Bank of America acquired Merrill Lynch in 2009 for $ 50 billion” (Rusli). It’s worth noting that Merrill Lynch is the leading underwriter of securities globally and as an investment bank it offers underwriting services to corporations that issue bonds and shares as well as provides advisory and research services. The investment subsidiary company specializes in various securities including commercial papers, bonds (both floating and fixed) and loans, both long term and short term.
However in the recent past, Merrill Lynch investment bank has been sued on a number of occasions by the Securities and Exchange Commission for not meeting its requirements and for its poor performance. It’s clear that litigations are not the best as they carry contingent liabilities where if the court finds the company guilty, then it may be asked either to pay huge amounts of money for compensation or get suspended from the market or even get deregistered. This has serious implications on the company as it loses its reputation and may not be in a position to cover its debts if it becomes insolvent.
Besides, the Merrill Lynch is considered to be providing the best training in the banking industry to its financial advisors although many analysts feel that the investment bank is after reaping heavily from profitable deals while forgetting its other mission of maintaining its position as the number one underwriter worldwide.
Hence, Merrill Lynch can issue a commercial paper as well as facilitate the issue of the same by other corporations since it can act as an underwriter for this short term security. In addition it can provide underwriting for itself and obtain commercial services from its mother company and this reduces the cost of finance that they could have incurred if they outsourced the services from other entities.
On the other hand, the Bank of America can also issue a commercial paper to finance its loans both long term and short term, credit cards, salaries and wages to its employees and also to fund its short term debts that are yet to mature within a period of 270 days. Since it is a commercial bank, it can facilitate the issuance of its own paper and that of other companies by taking deposits to purchase the paper and paying the investors on maturity.
The bank relies on loans for its income in terms of interests charged to loan customers. Usually, the interest and exchange rates vary over time depending on the global economic situation. Since the bank has other subsidiary companies based in foreign countries, it experiences serious effects of fluctuations in foreign exchange rates, which in turn affects short term borrowings and deposits. This is because customers may not be willing to deposit their money in banks when they expect fewer returns and also, they cannot go for loans when the interest rates are sky-rocketing. When the cost of borrowing from the Federal Reserve is high, then the banks are forced to shift these costs to the customers who shall be required to pay high interest rates.
It’s of essence to note that, the Bank of America relies heavily on mergers and acquisitions, a factor that has contributed to the bank’s growing asset base. However, these acquisitions carry some disadvantages such as change of the holding company’s organizational structure to accommodate the new subsidiary companies, change in management of the entity as it requires general skills and experience in running such a multibillion asset company and probably a transition of the holding company’s information system from the old one to facilitate efficient communication. All these transitions have cost implications on the holding bank.
The other blue chip company that can issue a commercial paper is Coca Cola. This is an industrial company that manufactures soft drinks (Sprite, Fanta, Coke, Stoney, bottled water among others) and their unique taste has been a secret for many years, something that has given them patent rights thus protecting their products from imitation.
The company is facing serious competition from Pepsi Company that is producing substitute products in which they have employed both cost and differentiation generic strategies to counter the moves of Coca Cola worldwide. In response, Coca cola has expanded its markets globally to widen its market share and it also keeps on come up with new innovations.
To enhance its capital requirements, Coca Cola can issue a commercial paper to raise funds (working capital) that shall take care of its daily operations, facilitate current asset transactions such as purchase of inventories, pay salaries and wages to its workers and other short term debts.
An asset backed commercial paper came into the market at around 1983 to allow companies that are considered more risky to participate in the issuance of commercial papers. Some companies that use this paper are those that deal in Corporate Asset Funding. However, these entities are required to do so with collateral that may involve their trade and credit card receivables.
To meet the required value of collateral, they are allowed to cooperate with other small entities and pool their receivables. This pooling of receivables is also facilitated by the commercial banks. This approach of issuing commercial paper secured by collateral has influenced some blue chip companies also to adopt such a strategy because there is more trust on the side of investors who feel the risk involved in such transactions has been lowered significantly.
Indeed from the analysis of the issuers above, it’s clear that to make a decision on which one of them is better isn’t easy but you can be able to do so from the pros and cons of each. “In the recent past some companies including Coca Cola have opted for corporate bonds as an alternative source of finance given that they were badly hit by the late 2000s global financial crisis” (Anusha).
When it comes to GM, it is a profitable company but the global economic recessions seem to throw it off balance when they occur as it was the case in 2009 when it was funded by the US government. Besides, GM faces competition from Ford and Toyota companies that are competing for foreign markets and this may see the company fall once again in the future.
On the other hand, the Bank of America is a holding company that relies heavily on the stability of both interest and exchange rates that are also affected by the global economic climate. If Merrill Lynch loses in a law suit, its holding bank can bail it out. Besides the Bank of America’s over-reliance on mergers and acquisitions may see it fail. However, Corporate Asset Funding entities stand at a better position since its commercial paper is secured by collateral. Hence, Corporate Asset Funding is better compared to the rest followed consecutively by Coca Cola, Merrill Lynch, Bank of America and GM.
The major dealers in a commercial paper are “investment banks which act as underwriters when companies issue securities such as stocks, commercial papers and when governments issue treasury bills and bonds” (Felix 35). They also assist in mergers and acquisitions, foreign exchange and marketing securities but they do not accept deposits. They assist investors such as pension funds and other companies to meet their obligations. For instance, if the pension fund wants to pay social befits to its customers, the investment bank shall provide advice and assist it to purchase commercial paper that can help finance the short term obligations.
In this case, the investment bank acts as a dealer and purchases the commercial paper from the issuer and then resells it to the investors. The dealers can at times be independent or be under an investment bank as in the above case. The issuer of the paper decides on its selling price and the dealer has the responsibility of providing the issuer with nature of the market conditions in terms of the demand for the paper.
In the 1980s the banks also became dealers and this increased competition in the industry. This was possible because of failure to enforce the regulations that barred such an entry and in turn, the competition led to a drop in profitability among the dealers and as result, major investment banks which had dealers were forced to exit the market. It’s worth noting that dealers also buy commercial papers from both issuers and investors to keep it in inventory and eventually trade it.
Sometimes the issuer company can issue the paper directly to the investors using its own agents in this case they can adjust the maturity period to suit with the investor’s needs. Hence, the use of an investment bank as a dealer is better and beneficial to the issuer because it can offer additional services regarding investment of the funds collected.
The major investors in the commercial paper of the US market the Money Market Funds, Commercial bank trust department, non-financial corporations, life insurance companies and government pension funds. The Money Market Mutual Funds (MMMFs) invests in short term securities such as the commercial paper, short term bonds and treasury bills because they provide better returns on investment.
Small investors who are unable to access a commercial paper because of its large denominations have the opportunity to do that through the MMMFs. Most of these institutions offer good returns because they also gain high interest rates from prudent investments that are managed by their professional financial analysts.
Adams argues that “life insurance companies also invest in commercial papers to diversify their investment portfolio so that they can get additional funds from the interest paid at maturity of the paper to finance their liquidity” (56). They also use the premiums that they acquire from individuals and put them into short term investments such as treasury bills because they offer returns within a short span of time. These funds also help in financing salaries of employees and the costs they incur in compensating life insurance policies that involve payment of a lot of money.
On the other hand, commercial bank trust departments also invest in this commercial paper to raise working capital. These entities perform the fiduciary of trust in which they transact financial assets on behalf of the customers. They act as trustees where they manage estates, inheritance and assets on behalf of the owners.
In case the owners of a given estate passes on, the trustee has the responsibility of ensuring that any tax liability has been assed and paid, they also ensure that debts are collected and if there was any outstanding debt, the trustee facilitate payment of the creditors.
For inheritances they ensure the right beneficiaries have been awarded and when it comes to assets, the trustee assists the investors to manage the asset portfolio.
Moreover, the government pension fund invests in the commercial paper to raise additional income to cater for contingent pension liabilities that may arise in the future. Employed persons are required to make regular remittances to a pension scheme and these contributions eventually help them to finance their future projects when they retire. They also use the interest obtained from this paper to cover the costs incurred in running the scheme such as salaries to the managers and subordinate staff.
Besides, a non financial corporation can also invest in commercial papers to diversify their investment portfolio. A non financial corporation is an entity that produces goods and services that do not directly involve finance as in the case of banks. Hence, from the analysis of the investors the Money Market Mutual Funds (MMMFs) are better than other investors we have discussed because they specialize in investments and thus have a wealth of experience in commercial paper transactions.
In conclusion, commercial papers provide an easy access to funds for companies in a financial crisis in which they can sell these papers to raise short term funds to cater for working capital, current asset transactions and pay for employees’ salaries.
However this option of short term borrowing is only available to blue chip and reputable companies excluding small entities that can only participate in these transactions through Money Market Mutual Funds.
The issue of commercial papers involves issuers, dealers, investors and commercial banks. The issuers produce a prospectus and then after its circulation in public they issue the paper through dealers who purchase it and then resell it to the investors. However, the dealers can also purchase the paper from the investors and keep it in inventory and trade it later. The commercial banks facilitate these transactions involving receiving and payment of cash for the paper.
Works Cited
Adams, Kelly. Financial Management: Short-term Securities. New Haven: Yale University Press, 2001. Print.
Anusha S. Re: It’s Catch-22 for the Commercial Paper Market. 2011. Web.
Brady D. Re: Record Profits but Still Mixed Success at GM. 2012. Web.
Felix, Robert. Introduction to Finance: Commercial Paper. New York: Routledge, 2006. Print.
Persie, Stacy. Financial Planning: Raising Short-term Funds. Boston: McGraw-Hill, 2005. Print.
Rusli E. Re: The Universal Appeal of BofA. 2008. Web.