Commercial paper: more risk, less return
Considering investing in commercial paper? Think again. It offers lower rates than money markets and requires more scrutiny.
The tricky part is weighing benefits against risks for each issue, because commercial paper isn’t insured by the Federal Deposit Insurance Corp.
Commercial paper is short-term, unsecured debt issued by corporations. Firms use this money to finance operations, because rates are usually cheaper than those for their long-term debt. But don’t expect higher yields to compensate for the added risk.
“These days, commercial paper has low rates,” says Bob Williams, senior vice president of Delta Trust Investments in Little Rock, Ark. For example, UBS’ 30-day commercial paper paid 0.06 percent in mid-June, which is lower than money markets.
Little-known to investors, commercial paper is similar to zero-coupon bonds. Both are issued at a discount and accrete at the face value. Maturities on commercial paper are less than 270 days, capped by government restrictions. But the commercial paper market is big and growing, currently amounting to more than $1.162 trillion, according to the Federal Reserve. Issuers are usually highly rated companies, making the paper fairly liquid because there’s less risk and more investor demand. Lower-rated commercial paper typically means more risk and less demand.
For future big purchases
On the upside, commercial paper is a good place to sock away large amounts of money for big, future purchases. Minimum investments usually amount to $100,000.
But commercial paper is unsecured, and not backed by assets of any kind, says Eric Randolph, portfolio manager at Hopwood Financial Services Inc. in Great Falls, Va. Jittery investors may want the comfort of insured money markets instead.
Here’s a rundown of risks to consider:
- It trades in large increments. Though it usually sells for $100,000 per issue, some brokers chop it up into smaller $10,000 increments. “This rules out lots of investors,” Williams says. For investors with less cash, money markets that invest in commercial paper are a better bet.
- Interest on commercial paper is taxable. Parking lots of money in commercial paper means you’ll get hit with taxable interest. “If you’re wealthy, there may be a better place to go,” Williams says.
- They’re not FDIC-insured. Because commercial paper is issued by corporations and not financial institutions, you forgo any FDIC insurance. Instead, your investment is secured only by the company’s income flow and not by assets. “And if the flow is gone, so is your security,” says Daniel Wesley, chief executive officer of CreditLoan.com and a commercial paper investor. “You’re hedging your bets.” However, defaults are rare, he says.The Securities and Exchange Commission doesn’t regulate the commercial paper market. So, Wesley advises investors to carefully select issues, looking at creditworthiness. Check commercial paper ratings at Moody’s or Standard & Poor’s, which assign credit ratings.
- Diversification is more difficult. Because commercial paper denominations are so large, spreading out your risk among lots of issues is challenging. “Under $500,000, your investment risk is spread too thinly,” Wesley says. “You’re safer with over $1 million to invest.”
Conversely, money market funds that invest in commercial paper offer much more diversification since you’re spreading risk among many different issues. “Don’t put all your eggs in one basket,” Williams says.
Strong issues, lower interest
Recently, commercial paper paid a paltry 0.15 percent for 90-day paper issued by nonfinancial companies, according to the Federal Reserve. You can track rates at FederalReserve.gov. But money market funds paid a heftier 0.68 percent rate in late June, according to Bankrate’s rate search tool.
“Going with lower-quality paper means you’ll get higher rates,” says Randolph. But you’ll have to take more credit risks, he says.
Fortunately, highly rated companies usually issue commercial paper. Lesser-rated companies have difficulty selling their paper to investors. A stronger commercial paper market was spurred by the Lehman Brothers default in 2008. It crushed the commercial paper market and caused two money market funds holding paper to break the buck, which happens when net asset value falls below $1 per share. After that, even rock-solid corporations such as Coca-Cola Co. fled the commercial paper market.
“Mostly, you see big-name issuers like IBM, Cisco and Johnson & Johnson these days,” Randolph says.
Still, money market funds holding commercial paper have downsides, too. “You don’t know what’s inside your money market,” Randolph says. “With specific paper, you know what you’re buying.”