In our previous blog post, “The Rise of Commercial Paper in Corporate Finance”, we explored how commercial paper (CP) is becoming a go-to solution for corporations seeking short-term financing and individuals looking for high returns on investment.
This follow-up blog post dives deeper because being a smart investor means seeing the full picture. Let’s unpack what you need to know before investing in commercial paper.
If you missed the previous post, read it here.
Types of Commercial Paper
Commercial paper isn’t a one-size-fits-all instrument. There are several types, each tailored to specific corporate needs:
- Promissory Notes – Written, unconditional promises to pay a specified amount at maturity. Companies use it to borrow funds without providing any collateral.
- Drafts/Bills of Exchange – It is used primarily in trade finance. They are orders written by one party (the drawer) directing another party (the drawee) to pay a particular sum of money to a third party (the payee)
- Asset-backed Commercial Paper (ABCP) – Backed by collateral, usually financial assets like loans, leases, trade receivables, or credit card debt.
Understanding which type you’re investing in is the first step in assessing the potential risks.
How Do Individuals Invest in Commercial Paper?
While CP has traditionally been the territory of institutional investors and money market funds, individuals can now get in on the action through:
- Mutual funds or money market funds that include CP in their portfolio.
- Brokerage firms that offer direct access to CP from large corporations.
- Investment platforms or fintech firms facilitating fractional investments in CP.
Each method has varying levels of transparency, accessibility, and risk. Always know who is issuing the paper and who is managing your investment.
The Risks Associated with Commercial Paper
Even though CP is often considered low risk, it’s not risk-free. Here’s what you need to be aware of:
- Credit Risk: Commercial paper is unsecured. If the issuer defaults, investors may lose their capital.
- Liquidity Risk: CP may not be easily tradable, especially in stressed markets. You might not be able to exit early without taking a loss.
- Market Risk: Interest rate changes can affect returns, especially if you are holding CP in a broader portfolio.
- Structural Risk (in ABCP): If collateral behind asset-backed CP deteriorates, so does the paper’s value.
How Can You Protect Yourself?
Protection starts with due diligence:
- Stick with highly rated issuers (A-1/P-1 or higher).
- Choose CP with shorter tenors to reduce exposure.
- OPT for CP funds managed by reputable institutions if you’re new to the space.
- Don’t put more than a small percentage of your portfolio in CP. It’s a tactical move, not a core strategy.
Key Investor Risks to Watch Out For?
Here’s a red-flag checklist:
- Declining issuer credit ratings
- Unfamiliar or opaque issuing entities
- Overly high returns that seem too good to be true
- Lack of transparency on terms and collateral (especially for ABCP)
- No secondary market may be locked in until maturity
Even seasoned investors can get burned if they overlook these warning signs. Are you thinking about investing in Commercial Paper, or want to learn more? Reach us at info@fcslng.com for personalised guidance.