Commercial paper is a financial instrument issued by corporations to provide funding for operating expenses and meet 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.
Money market funds get their name from commercial money markets, which are exchanges where corporate treasurers buy and sell huge amounts of commercial paper to manage their cash flow. Can an individual get in on this corner of the financial world? If so, is that a good idea?
How does commercial paper work?
Corporations issue commercial paper to obtain ready cash, in exchange for which they commit to redeeming the paper when due for more than its issue price. This is known as trading at a discount -- commercial paper does not make interest payments like a bond, but its yield is derived from the difference between the maturity value and value when issued.
Commercial paper is designed to trade in high volume, so it is usually denominated in values of $100,000 or greater. Because of its short-term nature, holders of commercial paper roll maturing paper over into new issues frequently.
Yields on commercial paper vary according to the creditworthiness of the issuer. As of this writing, high-quality, 90-day commercial paper was yielding just over 2 percent on average, while lower quality paper was yielding 2.60 percent. At the same time, bank money market yields were averaging 0.12 percent and three-month CDs were averaging 0.14 percent.
In addition to yields moving up and down generally over time (commercial paper rate averages usually move higher when the economy is growing), the relationship between higher and lower quality commercial paper yields also varies according to the credit-risk environment. Under some circumstances, bank products can actually yield more than commercial paper.
Can I buy commercial paper?
Commercial paper is usually traded among large institutions, but individual investors can participate in two ways:
- Individuals can buy commercial paper from a broker. However, since commercial paper is typically traded in increments of $100,000 or more, it takes a substantial investment.
- Retail investors can put money in funds or money market accounts that invest in commercial paper. This allows you to get into the market with a smaller investment, though management fees and active investment costs are likely to dilute the yield.
Is commercial paper risky?
Broadly speaking, commercial paper is considered to be a fairly low-risk investment because of the extremely short-term nature of the securities. However, that does not mean it is risk-free, especially from the point of view of an individual considering it as an alternative to money market accounts, savings accounts or CDs.
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.
Here are some of the risks you can face investing directly in commercial paper:
- No FDIC insurance
If you are thinking of commercial paper as an alternative to bank deposit products, a crucial distinction is that commercial paper is not backed by FDIC deposit insurance.
- Default risk
The lack of FDIC insurance is significant because occasionally corporations default on their credit obligations in times of financial distress. This could cause you to earn less than you expected on a commercial paper investment, or even lose money.
- Diversification is difficult
With commercial paper trading in increments of $100,000, most individuals would have a hard time assembling an investment portfolio with paper from enough different issuers to effectively diversify away default risk. This means even a partial default by one of the issuers could wipe out the yield earned from all the others.
- Trading costs
Commercial paper is generally traded in very high volumes by sophisticated corporate treasury departments. An individual trying to get into the market would likely be at the mercy of a broker, whose charges would eat into the yield.
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.
Though you may not always earn as high a yield as direct investors, keep in mind that you can get some of the yield characteristics of commercial paper by depositing in bank money market products. As long as you keep those deposits at any one bank below the $250,000 FDIC insurance limit, you can earn your yield with less risk and a lot less aggravation than by investing directly in commercial paper.