Commercial Papers (CPs) are money market instruments issued usually by blue chip companies with great credit ratings due to its unsecured nature being an IOU essentially.
CPs are issued at a discount (i.e. the face value on a CP is received by the holder upon maturity but a lesser amount is paid by the holder on purchase of the instrument).
For example; Paint Nig Ltd is issuing a CP at a 15% discount for a Maturity period of 150days. Mr. Brush makes this investment buying at NGN85,000. Upon maturity (150 days) Mr. Brush shall receive NGN100,000. The ROI is NGN15000 (15% of NGN100,000 i.e. face value of the CP issued by Paint Nig Ltd)
Why do commercial papers exist? Simply for the purpose of working capital management. It Proves to be cost effective being a low-cost alternative to bank loans. Mostly used to finance payroll, inventory, payables, income tax payables, lease payments etc.
Same as Treasury Bills? Not quite, the major difference being the level of risk. Treasury bills can only be issued by the government through the CBN (central bank of Nigeria), short term government securities. Commercial papers however are Non-government securities the most assurance often given is the credit rating of the issuer of the specific commercial paper.
Can commercial papers be traded?
Yes. How so? CPs can be traded before their maturity date at the prevailing interest rate during the time of sale.
What to Look Out For.
It is a generally accepted principle that the higher the risk of an investment the higher the return on that investment should be consequently.
The lowest form of risk on any investment is that taken on Treasury bills, so much so that they are tagged “Risk Free”.
Any Commercial Paper worthwhile must give a significantly higher Return on Investment (ROI) than what is obtainable on Treasury bill to compensate for the increased level of risk.
Credit Rating of the Issuerhttps://broadstreetfinancialreview.com/2020/10/26/commercial-papers/:
Credit Rating Agencies are responsible for classifying the credit worthiness of institutions. Indigenous SEC approved credit rating agencies are Augosto & co Ltd, DataPro Ltd and Global Credit Ratings Co Ltd. This is the most assurance investors get on CPs.
As earlier mentioned, CPs are issued at a discounted price. The return on CPs can be determined by calculating the difference on the face value and the purchase value of the instrument. This percentage of the return ideally should be higher than the risk free (Treasury bills) return on investment.
The maturity date of a CP can range from 30 days to 270 day.
There are two categories of CPs being “Dealers Paper” and “Directly Placed Paper”. The former being CPs issued by corporation to investors through third party financial institutions like stockbroking firms etc. The latter Directly placed Paper like the name connotes is directly placed by corporations directly to investors without the use of third parties.
Stay Tuned for Part II