Looking for a low-risk means of diversifying your investment portfolio? Then you may want to consider investing in commercial paper. No, we’re not talking about buying stock in a paper company (though Dunder Mifflin would be our first choice). This type of investment is used by corporations to finance short-term debt obligations. Here’s how to invest in it, and the pros and cons.
Investing in Commercial Paper
Commercial paper is a fixed-income security used by large corporations or banks to meet a short-term financial need. When you invest in commercial paper, you are paid a fixed interest rate plus the note’s principal balance upon its maturity. Since these are short-term securities, they reach maturity in 270 days or less – usually, between one and six months. Commercial paper can take the form of U.S. Treasury bills, certificates of deposits (CDs) or promissory notes.
Not just anyone can get into this investing game. That’s because these securities are most often issued in denominations of $100,000 or more. In fact, the commercial paper market is largely made up of large financial companies (think investment firms and mutual funds). However, individuals with the right amount of money can invest via a broker.
It’s worth noting that although commercial paper is similar to a bond, it does not make regular interest payments. Rather, you make money on it by the difference in its face value (what you paid for it) and the difference of its value at maturity, plus the agreed-upon fixed interest rate.
What Are the Benefits?
Many of the benefits of investing in commercial paper lie with the issuer. This is because it’s an easy way for a company to gain short-term financing for a big project. It’s cheaper than a traditional loan, doesn’t require collateral (remember, it’s an unsecured debt) and is relatively short-term since commercial paper notes reach maturity in 270 days or less.
Commercial paper isn’t required to be registered with the Securities and Exchange Commission (SEC) either, due to its short-term nature. For investors, it offers a return on investment in a fairly short amount of time. Plus, it’s pretty low-risk.
While it pays a fixed interest rate and can be an easy way to get a return on your investment, it’s not without its downfalls. For example, commercial paper notes are not FDIC-insured. This means that if the company you bought the paper from defaults, you lose your investment.
Commercial paper is also unsecured debt. This means that it’s not backed by collateral. These debt securities are issued based on the company’s projected ability to pay it back.
But don’t let that scare you off. Commercial paper is widely considered to be a low-risk investment due to its short-term nature. Though you should definitely do the legwork on the issuing company – check its S&P rating, financial health and potential risk for default – before signing on the dotted line.
The Bottom Line
Investing in commercial paper can be a short-term investment strategy to earn a healthy return on investment with moderate risk. However, since these notes often appear in denominations of $100,000 or more, it may be difficult to break into the market as an individual investor. Talk to your broker or financial advisor on how to add this type of investment to your portfolio.
Tips for Investors
- Commercial paper is not FDIC-insured. It’s also unsecured debt. This means that before investing in it, you may want to do your due diligence on the issuing company and take stock of its risk of default.
- While commercial paper offers a return on investment in 270 days or less, it’s paid at maturity, not periodically, like with bonds and other similar debt securities. It may be wise to consider all of your investment options before investing in commercial paper.
- Discussing your investment strategy with a financial advisor may help you make the right moves.Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/SARINYAPINNGAM, ©iStock.com/Milkos, ©iStock.com/Yok46233042