Bad paper is a term used in the finance world to describe some sort of debt instrument that is at an extremely high risk of default. Such a loan is offered by the issuer, which could be a corporation or even a local or national government, without any sort of collateral. As such, bad paper is extremely risky for investors, who would have no recompense if the issuer defaults. To interest investors in these types of fixed-income instruments, issuers often have to sell them at a discount and attach interest rates higher than would be associated with secured debt.
When a company or other institution is in need of funding for conducting business or some new initiative, they often turn to investors as the source of this funding. Investors can give loans to these institutions by buying bonds or other debt instruments intended to return a fixed income in the form of interest payments. If the issuer of the debt can offer no collateral, investors are taking a huge risk should the issuer default. These types of debt instruments are known as bad paper.
Investors who are looking for high rewards from the money that they invest might be tempted to take a chance on bad paper. In part, this is because these investments are usually purchased at a discount to other similar instruments. In addition, the issuers might have to raise the interest rates to lure investors and raise the necessary finding.
There are serious drawbacks attached to investing in bad paper. The distinguishing characteristic of such instruments is that there is no collateral backing them. That essentially makes them unsecured loans, which means that investors have to hope that the issuers will fulfill their debt obligations. If that doesn’t occur, there is nothing that investors can do to recover the capital that they originally invested. As a result, the potentially high rewards are accompanied by risks that might outweigh those rewards.
Most bad paper issuances are done by corporations that are at a high risk of default. For that reason, these companies are generally saddled with poor credit ratings by the agencies in charge of monitoring them. Investors can thus be clued into the possibility that the investment might be significantly risky by the presence of a low rating. The worst of these debt instruments can do extreme damage not only to individual investors but also to entire economies.