This fortnight, Concepts introduces Commercial Papers (CPs), a short term capital market product used by corporates to raise funds. Commercial Paper refers to a short term, unsecured, negotiable usance promissory notes with a fixed maturity, issued by rated companies at a discount to face value. CPs are issued by corporates as an alternative source of working capital finance.
All CP issues have to be mandatorily rated by one of the credit rating agencies in India. The minimum rating required is P1 or equivalent. However, most of the issues are from corporates rated P1+.
Pricing
CP’s are issued at a discount to face value and are redeemable at par on maturity. The discount actually is the effective interest rate.
Face Value / ( 1+ Discount Rate * No. of days / 365)
For e.g. A corporate issues a CP at an effective rate of 10.00% for 90 days. This is a discounted instrument and hence is actually issued at Rs. 97.5936 per Rs. 100. This means that the corporate gets Rs. 97.5936 on issuance and has to redeem back Rs. 100, on the maturity date after 90 days. This is calculated as follows:
Rs. 100 / (1+10.00% * 90 / 365) = Rs. 97.5936
Interest is calculated on an Cctual/365-day year basis. Typically CPs are issued for periods of 30/ 45/
60/ 90/ 120/ 270/ 360 days.
Investors
Eligible investors in CPs are individuals, corporates, unincorporated bodies, insurance companies and banks. Non resident Indians can invest in CPs on a non repatriable, non transferable basis. Banks and Indian companies are the most common investors. Initial placement is invariably done with banks due to a difference in stamp duty structure. Issue of commercial paper is subject to payment of stamp duty. The stamp duty on a primary issue of CP is 0.25% for all other investors, with a concessional rate of 0.05% for banks. Secondary market transactions (CPs are actively traded in the secondary market) do not attract any stamp duty.
Mode of Issuance:
While an option is currently available to both issuers and subscribers to issue CP in dematerialized or physical form, with effect from June 30, 2001, banks, Financial Institutions, Primary Dealers and Satellite Dealers are directed to make fresh investments and hold CP only in dematerialized form. Outstanding investments in scrip form in the books of banks, FIs, PDs and SDs should also be converted into dematerialized form by October 31, 2001. Thus, with effect from November 1, 2001, these entities will hold CPs only in dematerialized form.
Issuing and Paying Agent
Every issuer must appoint an Issuing and Paying Agent (IPA) for issuance of CPs. Only a scheduled bank as per Banking Regulations Guidelines can act as an IPA for issuance of CPs. The issuer should disclose to the potential investors its financial position as per the standard market practice.
Secondary Market Trading:
Trading is done over the counter with the counterparties involved. However, trading may also be done through brokers. As mentioned above, CPs are issued as promissory notes and do not attract any stamp duty on secondary market transfer. Anyway, with the issuance of CPs in the dematerialized form, it would not attract any stamp duty.
These instruments are normally issued in multiples of Rs 5 cr. CPs can be issued in denominations of Rs.5 lakh or multiples thereof. The amount invested by any single investor should not be less than Rs.5
lakh (face value). Secondary market settlement is done on a DVP, i.e. delivery v/s payment basis.
Suppose, an investor invests in a CPs of a company maturing in 90 days at 10.00%, i.e. it pays a price of Rs. 100 / (1 + 10.00% * 90 / 365) = Rs. 97.5936.
After 30 days, it is seen that CP interest rates have fallen, and it sells the CP at a rate of 9.50%. The remaining maturity of the CP is 60 days. The price at which it sells will be calculated in the same manner.
Rs. 100 / ( 1 + 9.50% * 60 / 365) = 98.4624.
The investor, hence, has a capital gain of Rs. 0.8688.
Obviously, as the maturity date approaches, the price tends to Rs. 100.00
Factors affecting the Pricing
CP being a short term instrument, its primary and secondary market determination of the interest rate, i.e. the discount rate, depends upon conditions in short term money market. The following are the principal factors in pricing of the CPs:
Inter-bank call rates
Since, call rates affect all the other short term rates, and banks are the most important investors in CPs, its pricing is affected very much by call rates. Also, as the lenders in the CP market are predominantly banks, call markets affect CP market rate; lower call rates mean cash surplus banks will view CPs as an alternative investment route.
Competing Money Market Investment Products
Interest rates on CPs are determined by the demand and supply factors in the money markets and the interest rate on the other competing money market instruments such as Certificates of Deposit, Commercial Bills, Short Term Forward Premias and Treasury bills. The investments in CPs gives comparably higher yields than those obtained in bank deposits of similar maturities.
Liquidity
Pricing and availability of funds under CPs are determined by the liquidity amongst banks and mutual funds, which are the principal investors.
Credit Rating
Most of the secondary market investment in CPs are done only in P1+ (highest CRISIL rating for short term credit instruments). However, two P1+ companies may not attract the same rate, due to relative credit perception amongst different companies, and also, till an extent, the company’s long term credit ratings.
Taxation
For the Corporate:
The discount is treated as an interest expense, deductible for tax purpose.
For the Investor:
Profit/loss on sale of investment
Income is taxed under the head “Profits and Losses from Business and Profession”. Losses are allowed as business losses. This is for banks and investment companies. For, corporates that invest in other company’s’ CPs, this would be Other Income / Interest Income.
Tax Deducted at Source
The CBDT vide Circular No 647 dated 22nd March 1993 has clarified that the difference between the issue price and the face value of the Commercial Papers and the Certificates of Deposits is to be treated as 'discount allowed' and not as 'Interest paid'. Hence, the provisions of the Income-tax Act relating to deduction of tax at source are not applicable in the case of transactions in these two instruments.
DISCLAIMER
The above views are based on the latest available information. Though the information sources are believed to be reliable, the information is not guaranteed for accuracy. While the views are proffered with the best of intentions, neither the author, nor the firm are liable for any losses that may occur as a result of any action based on the above. The financial markets, and especially the Indian money markets, are illiquid and inherently risky and it is assumed that those who trade these markets are fully aware of the risk of real loss involved.
Unauthorized copying, distribution or sale of this publication is strictly prohibited.
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