Asset-backed commercial paper

banking

Asset-backed commercial paper is a short-term financing instrument used by companies, which involves the recognition of commercial debt, and is protected by financial assets.

The company issues commercial paper as a measure to finance its short-term resources: inventories, customers, etc. The company's objective is to obtain financing in the very short term, normally within a maximum term of 270 days. In this way, the company obtains immediate liquidity in case its cash needs require it.

When the commercial paper is asset-backed, the owner of the commercial paper has a greater guarantee in the event of default from the issuer. Therefore, the interest charged is less than commercial paper that is not asset-backed.

How Asset-Backed Commercial Paper Works

Asset-backed commercial paper can be issued and traded on the stock markets. In practice, it is similar to treasury bills, that is, they are instruments that are issued at a discount. Therefore, investors will pay less for commercial paper than they will receive at maturity.

This implies that the interest rate paid by the company will depend on the discounted price of commercial paper paid by the investor. In other words, the higher the market discount, the less liquidity the company receives and therefore the more interest it pays. The operation could be summarized in three steps:

  1. Issuance of commercial paper: The company issues commercial paper on the financial markets.
  2. Purchase of commercial paper: Investors buy commercial paper and at the same time the company obtains the liquidity it was looking for.
  3. Maturity of the commercial paper: The company will pay at maturity, an amount higher than that received for the issuance of the commercial paper.

The type of assets that usually back this type of commercial paper are credits to clients or accounts receivable. That is, they are backed by cash flows that the company will obtain in the future, for its current collection rights.

Advantages of asset-backed commercial paper

The main advantage comes from its difference from standard commercial paper, that is, not backed by assets. Since it has a series of assets as collateral, the financing instrument has a lower risk for the investor.

On the other hand, by having less risk, the company will pay a lower interest rate for the financing obtained. Assuming this instrument a good alternative to other sources of short-term financing such as the line of credit.

Disadvantages of asset-backed commercial paper

Like assets that act as collateral, they reduce the risk for the investor, they can also increase it. Remember that the guarantee depends on the future income of the company from its commercial credits granted.

But what happens if your clients do not pay their debts with the company? It could be the case that clients do not pay their credits, as for example, it can happen during an economic crisis. And this would imply a high risk for the amortization of the nominal by the investor. In fact, it was one of the serious problems in the United States during the last great recession.

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