The Fall And Rise Of The Cp

After two years in hibernation, the market for commercial paper (CP) has made a comeback. Helped by a liquidity overhang in the financial system and recent relaxations in the credit policy, banks have, over the past few months, been subscribing with renewed enthusiasm to CPs, which is essentially short-term corporate debt.

Till the CP market re-emerged, banks would have deployed funds in the short-term government securities markets mostly T-bills with a maturity cycle of anywhere between 30 days to 60 days.

These alternatives are not attractive today. With short-term yields crashing, T-bills for 91 days tend to give a maximum yield of 6.5 per cent. This is actually lower than the 30-day deposit rates that banks are offering.

 

Short-term corporate debt, on the other hand, offers yields of 9 to 10 per cent depending on the rating of the instrument.

The lower end of the band is usually reserved for corporate debt rated P1 and above. Lower -rated paper offers around 10 per cent.

Companies typically issue the instruments for 30 days and roll over the instrument at the end of the period. This allows them to take advantage of the low short-term rates. If tenures were longer at the outset, the rates would be higher.

The cheaper option

Companies find the CP route a convenient financing method. This is because bank finance does not come cheap, even in an environment of falling interest rates. And that is especially so because 80 per cent of the maximum permissible bank finance (which corporates are still availing of), is in the form of a loan while only 20 per cent is in the form of cash credit.

This is because the interest on the loan portion is levied on the entire 80 per cent component. This is unlike the cash credit mechanism, where interest is levied only on the actual amount drawn, thus making bank borrowings cheaper.

As far as the loan component is concerned, most banks still charge about 2 per cent above the prime lending rate, which works out to 16 per cent plus for prime corporate borrowers.

Consequently, if they draw their entire working capital out of bank finance, companies do not get the benefit of keeping financial costs down.

This is given the fact that the loan component forms a large part of borrowers maximum permissible bank finance ( MPBF). Therefore, sourcing a part of working capital requirements in the form of CPs could help companies achieve this objective.

Says P S Jayraman, executive director, finance, of Chemplast Sanmar:"The best way to keep working capital costs down is to have a funding mix."

Currently, the working capital mix comes from bank finance, inter corporate deposits (ICDs), company deposits and commercial paper. Company deposits and ICDs currently offer about 14 per cent plus, taking commissions into account.

In the current environment of surplus liquidity, instruments like CPs are the cheapest source of working capital finance.

Instead of doing away with them altogether, companies are altering the working capital mix by reducing their reliance on company deposits, ICDs and bank borrowings.

The aim is to reduce the loan component of their working capital borrowings, and increase the CP component.

The advantage in using this is that interest costs are straightaway reduced by as much as seven per cent, even if a rollover at a one per cent increase at the end of 30 days is factored in.

Why banks like CPs

Banks find this method of funding extremely convenient, especially when consortium lending is no longer the rule of the day. Subscribing to CPs allows banks an easy exit option or a short-term arbitrage option.

The arbitrage technique essentially revolves riding the yield curve and booking capital gains. Subscribing to CPs has also become necessary for banks to balance large volumes of short-term deposit accretions, especially in the under- six month categories.

For banks that have a portfolio of 30-day deposits, subscribing to CPs is the most profitable operation since spreads are around three per cent.

After factoring in the statutory liquidity ratio (SLR) and cash reserve ratio (CRR) element for short term funds, spreads work out effectively to about 2 per cent plus for the banks.

In fact, banks like Corporation Bank, Bank of Baroda and HDFC Bank have booked huge gains through such operations.

Waiting for the critical mass

Although the number of CP issuers is increasing, the market is still to acquire critical mass.

In current market conditions, only top-grade corporates would be able to issue such paper successfully though second rung issuers are using ingenious mechanisms to enter the market. As a result, there is a lack of depth in the CP market.

This is unlike in 1994 or early 1995, when issuers used the standby facilities offered by banks and tapped the market.

Standby facilities are essentially a system by which banks automatically re-instated borrowing limits to companies without a fresh appraisal. This was viewed as a comfort factor in favour of the CP issuerby both the subscribing banks and the credit rating agencies, since it reduced the borrowers reliance on its own cash flows. This facility was scrapped by the Reserve Bank of India two years ago because of the scope for misuse that the system allowed.

Other products like revolving underwriting facilities (RUFs) which imparted a high level of liquidity to instruments like CPs, have not taken off.

Revolving underwriting facilities are usually for a full term, say, a year. Essentially, a syndicate of RUF underwriters could enable CP subscribers to exit from their investment in CPs before maturity.

In the process, the instrument becomes more liquid.

Since this facility makes it possible for initial subscribers to exit before maturity, it triggers greater demand for CPs of longer maturity.

If an issuer does not prefer to go in for rollovers (say, in anticipation of a liquidity crunch), the CP can be issued for the full maturity of a year on the strength of an RUF.

For the moment, though, companies are basking in the CP market.

With banks chasing such instruments, there has been a sharp fall in rates.

In fact, over a span of less than a month, CP rates have already dropped by about 400 basis points.

This fall in rates is becoming attractive for even potential issuers, who, under normal circumstances, may not be able to secure ratings good enough for issuing CPs.

Consequently, the variants that are developing in the markets are asset-backed CPs, that is paper backed by current assets like short term receivables.

These are mostly being issued by finance companies.

This asset backing as an alternative to using standby facilities or RUFs allows CP issuers to provide credit enhancement techniques without altering the unsecured nature of the instrument. The alternative for these issuers would have been to resort to high cost borrowings. As a result of these kinds of innovations, ratings could cease to be a restraining factor for commercial paper, which is slowly beginning to replace ICDs.

Currently working capital mix comes from bank finance, ICDs, company deposits and commercial paper. Company deposits and ICDs currently offer about 14 per cent plus, taking commissions into account.