The commercial paper (CP) market in India has grown substantially, and provides significant short-term funding to corporates today. Commercial papers enable issuers to raise funds directly from investors and hence, depending on the liquidity in the market, can enjoy favourable interest rates compared with bank loans.
CP issuances have almost tripled to Rs. 20.8 lakh crores from Rs 7.3 lakh crore over the three fiscals ended March 31, 2017. As on March 31, 2017, the CP outstanding amounted to ~Rs 4 lakh crore – almost four times as on March 31, 2014.
However, the commercial paper market is almost fully dominated by A1+ rated issuers, despite the Reserve Bank of India (RBI) allowing even A3 rated companies to issue CPs. Only a handful of corporates rated A1 currently issue CPs; most still rely on bank lending for their working capital requirements.
There is need to develop and deepen the market for A1 rated commercial papers. This would allow corporates to tap funding at lower interest rates, and also enable investors to diversify their portfolio to yield better returns without a substantial increase in the overall portfolio risk.
RBI has also recently announced its directions on CPs on August 10, 2017. As per the directions, issuers with total CP issuance during a calendar year of Rs.1000 crore or more are required to obtain credit rating for issuance of CPs from at least two credit rating agencies. The directions also strengthen disclosure requirements around the use of commercial paper proceeds, and can provide a further fillip to the development of the CP market.
Market size and returns of A1 rated CPs
Working capital debt of more than 250 companies rated CRISIL A1 exceeds Rs 65,000 crore, which can be potentially issued as CPs. The market for A1 rated CPs could exceed Rs 1 lakh crore if the working capital debt of companies rated by other credit rating agencies is also considered, presenting sizeable investment opportunities.
For perspective on returns investors can expect, the median cost of debt for CRISIL A1 rated companies was ~150 basis points (bps) higher than CRISIL A1+ rated companies during fiscal 2017. That’s the potential spread over A1+ rated CPs expected to be available to investors.
Risk- Return Arbitrage
Risk-adjusted return is the excess return offered by a portfolio over the required yield to cover expected and unexpected losses, including default risk. A1 rated commercial papers can yield risk-adjusted returns of ~100bps or more in excess of that available on A1+ rated CPs (Chart 1).
Higher risk-adjusted returns underscore adequate compensation for the credit risk and present a significant opportunity for investors to increase their portfolio returns while maintaining risk levels within manageable limits. However, the benefits of risk adjusted returns can be reaped only in a portfolio with adequate diversification.
Market yield represents average yield on commercial papers outstanding, maturing within four months (120 days). The yield is computed based on the credit risk premium over 91-day treasury bill rate.
Track record of CRISIL A1 rated papers
Such ratings are typically assigned to companies rated in the CRISIL A category on the long-term scale, which is an investment grade rating with adequate degree of safety in terms of timely servicing of financial obligations.
In the decade through 2016, only 0.59% of CRISIL A1 ratings defaulted within a year. The one-year stability rate was 86.44% and one-year upgrade rate was 6.47%, indicating ~93% of CRISIL A1 ratings remained at the same rating or were upgraded to CRISIL A1+ within a year.
As an additional safety feature, CRISIL insists that issuers of CRISIL A1 rated CPs maintain adequate liquidity backup to be able to tide over temporary liquidity mismatches when refinancing is difficult.
CRISIL’s stipulation of a liquidity backup is beneficial to both the issuer and the investors. Liquidity backup ensures that investors in the CP will be repaid in time and that the issuer can use the support of the credit lines from the banking system to overcome temporary cash flow mismatches.
In the past decade, majority of CRISIL A1 ratings that were downgraded remained in the investment grade post the downgrade.
Liquidity backup helps prevent defaults due to such minor shifts in credit quality as bankers may not revoke the facility used as backup in these cases (Chart 3).The benefit of liquidity backup is reflected in the fact that only one CRISIL A1 rated CP has defaulted in the past decade.
Win-Win for Issuers and Investors
Apart from the returns upside without significant risk, there are also potential portfolio diversification benefits. CRISIL A1 rated entities offer a range of investment options across sectors(Chart 4). Also, ~50% of CRISIL A1 rated entities belong to strong corporate groups, and enjoy significant support, which can provide additional comfort to investors.
As for cost savings compared with bank credit, issuers of commercial papers can potentially reduce their funding costs by more than 100 bps by meeting their funding requirements from the CP market, instead of traditional bank lines. The issuance cost of CPs is ~0.3% of the amount raised, which is marginal compared with the interest rate reduction of ~1.5% that may be available to issuers.
With A1+ rated CPs being the norm, it is time the market is expanded to include A1 as a means to optimize cost for issuers and at the same time extend a measured means of enhancing returns. It is indeed time for investments to pick up in A1 rated CPs, considering the huge market potential and higher returns, even after adjusting for credit risks.
The presence of liquidity backup on CRISIL A1 rated CPs can provide additional comfort to investors. The development of the commercial paper market for A1 rated CPs would also allow issuers to reap significant cost savings vis-à-vis bank credit, and diversify their funding sources
Ashu Suyash, MD & CEO, CRISIL, writes this piece for FICCI’s CAPAM 2017 Knowledge Paper.