What is Commercial Paper & Certificates of Deposit?

When companies or banks need short-term funds, they sometimes turn to money market instruments instead of traditional loans. Two well-known tools in India's financial landscape are commercial paper and certificates of deposit. Let's break them down in simple terms so anyone can understand.

What is Commercial Paper?

If you are curious about commercial paper, you can think of it as a short-term promissory note with no collateral to back it, issued by big corporations or financial entities. It allows these entities to borrow funds for a short duration (from a few days to a year) without the need for collateral to back its promise to return the face value of the note on a certain date. Due to its short duration, the interest cost can be lower than that of other borrowing methods.

Types of Commercial Paper

The types of commercial paper vary mainly by maturity period and the purpose of the funds. Some are issued for as short as a week, while others may run close to a year. Some may be tailored to seasonal business needs, while others help manage temporary cash flow gaps. Regardless of type, they remain a quick way for companies to raise funds.

Understanding the Commercial Paper Market in India

The Reserve Bank of India regulates the commercial paper market in India. Banks, corporations, and approved financial institutions participate actively. Investors like mutual funds, insurance companies, and other large institutions usually buy these papers. Retail investors typically access them indirectly through mutual fund schemes that invest in money market instruments.

How Investors Can Access the Commercial Paper Market?

Although commercial paper is primarily bought by large institutions, individual investors can still participate indirectly. One common route is through mutual fund schemes that invest in short-term money market instruments. These investments aggregate funds from a range of investors to buy high-quality commercial paper; these investments provide investors with diversification and the benefit of professional management.

Risks to Consider Before Choosing Certificates of Deposit

While the benefits of certificates of deposit include predictable returns and bank backing, investors should also note the risks. Interest rates can rise after purchase, which means you might miss higher yields elsewhere. Liquidity is another factor: although these deposits are negotiable, finding a buyer before maturity may not always be immediate. Evaluating the issuing bank's credibility and matching the maturity period with your cash needs is essential.

Benefits of Commercial Paper

There are many benefits of commercial paper for both issuers and investors. Companies get funds at competitive rates and can meet urgent financial needs without lengthy loan procedures. Investors find them attractive because they are usually issued by reputable organisations and can provide a fixed return over a short duration. However, like any investment, there is a level of risk, so due diligence is essential.

What Are Certificates of Deposit?

Alongside commercial paper, banks offer another instrument called a certificate of deposit. If you are asking what certificates of deposit are, picture it as a fixed-deposit like receipt issued by a bank for a specific period and interest rate. These are negotiable instruments, meaning they can be transferred from one holder to another before maturity.

Benefits of Certificates of Deposit

The benefits of certificates of deposit include the safety of bank-issued paper and predictable returns over a chosen time frame. They are useful for investors seeking a short-term parking place for surplus funds, with less market volatility than many other instruments.

Comparing the Two Instruments

While both instruments serve as short-term borrowing tools, their issuers differ. Commercial paper comes from corporates and financial institutions, while certificates of deposit are issued by banks. Both offer flexibility, but the choice depends on an investor's risk appetite and the issuer's credibility.

Conclusion

Familiarity with commercial paper and certificates of deposit may help investors and firms with decision-making in the Indian money market. These types of investments provide flexibility and short-term funding. Nonetheless, deciding upon the reputation of the issuer or the associated risk must be evaluated.

If you want to explore these options via a regulated platform, use Indiabulls Securities Limited (previously known as Dhani Stocks Limited) for trading services and access to markets, but remember that their brokerage charge will be no higher than those permitted by SEBI.

FAQs

1. Can an individual investor buy commercial paper directly?

Usually, large institutional investors participate directly in the commercial paper market. Retail investors can gain exposure indirectly through mutual fund schemes that invest in money market instruments.

2. Are certificates of deposit the same as fixed deposits?

Not exactly. Certificates of deposit are negotiable and can be traded before maturity, while a fixed deposit is a direct contract with a bank that typically cannot be transferred.

3. Do these instruments guarantee returns?

Both commercial paper and certificates of deposit carry market-linked risks. While banks back certificates of deposit, investors must still evaluate credit ratings and the financial health of issuers.

4. Are these suitable for long-term investment goals?

They are primarily short-term instruments. Anyone seeking long-term growth may look at other avenues, such as mutual funds or equities.