What Is Commercial Paper and How Does It Work?
One of the emergency steps announced by the Federal Reserve to fight the economic impact of COVID-19 is the creation of two credit facilities to support commercial paper securities.
If you are an investor interested in earning income, or even if you simply have a money market account, this action by the Fed may affect you.
What Is Commercial Paper?
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 up to 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.
The appeal of commercial paper is that it yields a little more than similarly liquid government securities. Investors seeking that extra yield can buy commercial paper directly. You can also capture some of that yield indirectly by investing in money market accounts or mutual funds.
Money market accounts get their name from commercial money markets, which are exchanges in which corporate treasurers buy and sell huge amounts of commercial paper to manage their cash flows.
Does it make sense for you to get in on this corner of the financial world at this time?
The answer depends on your situation and how you plan to invest.
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 is yielding just over 1.8% on average, while lower quality paper was yielding about 2.7%. At the same time, bank money market yields are averaging 0.12% and three-month CDs are averaging 0.15%.
In addition to yields moving up and down generally over time (commercial paper rates 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 by 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 from major rating agencies. A-1 is the highest rating issued by Standard & Poor's for short-term securities, while the highest quality rating from Moody's is P-1.
The Federal Reserve tracks commercial paper interest rate indexes that can help investors compare yields on commercial paper to other short-term investments.
If you can't afford to invest in commercial paper directly, you can get some of the yield characteristics of commercial paper by depositing in bank money market accounts.
Money market accounts from a bank have the advantage of being eligible for FDIC insurance. While these accounts may not yield as much as direct investments in commercial paper, you can improve your yield by shopping around for the best money market rates.