What is 'Bad Paper'

Bad paper refers to an unsecured short-term fixed income instrument with a high default probability, typically issued by a corporation.

These investments are not backed by collateral and are sold as a discount to similar collateral-backed fixed-income securities. They often carry below-investment-grade ratings and have comparatively high yields. Typically, maturities are 270 days or less and they sell at a discount to face value.

Few individual investors hold bad paper, partly because of the volatility, but also the high dollar value per issue -- most often $100,000.

Breaking Down 'Bad Paper'

Bad paper, as the name implies, is risky and carries with it the chance of permanent capital loss. Companies and governments offering bad paper usually need the money to finance operations in the near-term.

Bad paper differs meaningfully from investment-grade commercial paper, which tends to offer fairly paltry yields but has a very low chance of default, at least in theory.  Investors in investment-grade commercial paper are happy to get a yield higher than Treasury bill for taking on a degree of credit risk.

Notably, however, some highly rated commercial paper turned to bad paper during the 2007-2009 financial crisis. Very early in the credit crunch, commercial paper began to dry up, along with other short-term markets. Then, on September 16, 2008, The Reserve Primary Fund broke the buck when its net asset value (NAV) fell to 97 cents per share. It was one of the first times in the history of investing a retail money market fund failed to maintain a $1 per share NAV. The implications sent shockwaves through the industry. The commercial paper did not begin to start loosening up again until the U.S. Federal Reserve intervened and began to buy commercial paper.

Although the Lehman paper represented only a small portion of the Reserve Fund's assets (less than 1.5%), investors worried about the value of the fund's other holdings. Fearing for the value of their investments, worried investors pulled their money out of the fund. Unable to meet redemption requests, the Reserve Fund froze redemptions for up to seven days. When even that wasn't enough, the fund suspended operations and commence liquidation.

Pros and Cons of Bad Paper

Some very short-term bond funds still invest heavily in commercial paper as a way to pick up incremental yield over T-bills. However, none purposely invest in bad paper, even though the yields of these investments are significantly higher than T-bills and most other short-term fixed-income securities.

Notably, many money market funds no longer invest in commercial paper, largely due to money market reform that sought to avoid bad paper.

  1. Commercial Paper

    Commercial paper is an unsecured debt instrument issued typically ...
  2. Short-Term Paper

    Short-term papers are financial instruments that typically have ...
  3. Tax-Exempt Commercial Paper

    A tax-exempt commercial paper is an unsecured short-term loan ...
  4. Paper Profit (Paper Loss)

    A paper profit (or loss) is an unrealized capital gain (or loss) ...
  5. Paper Trade

    The paper trade is the practice of simulated trading so that ...
  6. Two Name Paper

    A two name paper is a nickname assigned to a legal agreement ...
Related Articles
  1. Investing

    An introduction to commercial paper

    Commercial paper, a type of interest collecting promissory note, is a short-term instrument that can be a viable alternative for retail fixed-income investors looking for a better rate of return.
  2. Investing

    Commercial Paper

    Commercial paper is a short-term debt security issued by financial companies and large corporations. The corporation promises the buyer a return, or profit, for making the loan. The return is ...
  3. Financial Advisor

    Money Market Mayhem: The Reserve Fund Meltdown

    This event serves as a stark reminder to investors about understanding their portfolios.
  4. Investing

    Five Paper Companies Licensed To Print Money

    Here's a sector that significantly outperformed the broader market year to date.
  5. Investing

    WestRock Boxes Up an Acquisition (WRK)

    One of the biggest names in cardboard, WestRock Company (NYSE: WRK), is getting a little bigger this week. On Tuesday, the company announced that it has signed a "definitive agreement" to acquire ...
  6. Managing Wealth

    Panama Papers Data Dump: Biggest Surprises

    First of all, there aren't 214,000 entities mentioned--there are more than 320,000.
  7. Investing

    2016's Most Promising Money Market Funds

    Learn information on some of the most promising money market mutual funds for investors to consider adding to their portfolio in 2016.
  8. Investing

    Getting To Know The Money Market

    If you need liquidity and safety on a sum of money, don't forgo potential interest by keeping the funds as cash.
  9. IPF - Banking

    What Is A Money Market Fund?

    Learn how money market funds provide security, but the returns may not be adequate for long-term investors.
  1. What are some examples of money market funds?

    Learn more about different types of money market mutual funds, including those that invest in government paper versus commercial ... Read Answer >>
  2. Why do banks write off bad debt?

    Learn more about the practice of banks writing off bad debts and removing them from their books, including a hypothetical ... Read Answer >>
  3. How does Federal Trade Commission use the Herfindahl-Hirschman Index to evaluate ...

    Understand specific examples of domestic products that rely on protective tariffs to survive. Learn about the varying tariff ... Read Answer >>
Trading Center