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.