Commercial paper for individual investors
January 10, 2011
Commercial paper is a financial instrument issued by corporations to providing funding for operating expenses and meeting short-term liabilities. Commercial paper is issued with a fixed interest rate and a maturity date of less than 270 days. Buyers of commercial paper are essentially purchasing promissory notes that are backed by the financial health of the issuing corporation. The federal government does not insure or implicitly back investments in commercial paper.
Commercial paper rates
Rates on commercial paper can be higher than other short-term cash instruments, reflecting the default risk and the needs of corporations to quickly raise financing. Mutual funds had a long history of using investments in commercial paper to boost the yields on their funds until the Lehman Brothers bankruptcy in 2008 severely rattled the commercial paper market. Mutual fund managers are now more careful about the commercial paper investments that they make for their money market funds.
Investors who enjoy the safety and security that FDIC insurance provides should remember that commercial paper investments are different than bank deposits. The FDIC insures certificates of deposit, money market accounts and savings accounts against the failure of a bank, but commercial paper is really nothing more than an IOU from a company.
Investors can check the safety of commercial paper issuers by checking the ratings issued by major rating agencies. AAA is the highest rating issued by Standard & Poor's, while the highest quality rating from Moody's is Aaa.
The Federal Reserve tracks commercial paper interest rate indexes that can help investors compare returns on commercial paper to other short-term investments. Commercial paper rate averages usually move higher when the economy is growing.
Who buys commercial paper?
Corporations have been issuing commercial paper for more than 100 years to large investors such as banks, mutual funds or brokerage firms. These entities buy commercial paper as an investment or act as a financial intermediary and resell the paper to their customers. Until recently, individual investors have been left out of the commercial paper market unless they used a broker for a private investment placement.
The growth of the Internet and the increase in online financial transactions has helped motivate some companies to try and sell commercial paper directly to individual investors online. Subsidiaries of several large companies have issued short-term notes that can be purchased in small amounts directly online with rates that beat many cash alternatives. Although these accounts resemble a money market account in ways that include the ability to make online transfers and write checks, it's important to note that investors are actually investing directly in the debt obligation of a private company -- with no FDIC protection.