What is Bad Paper?
Bad paper refers to uncollateralized bonds (typically with short maturities) that are poorly rated and at high risk of default.
How Does Bad Paper Work?
For example, let's assume Company XYZ is teetering on the verge of bankruptcy. In order to inject more cash into the company, it issues new bonds. But because Company XYZ's credit rating and financial stability is so low, it must issue those bonds at a deep discount and/or a very high interest rate. If the bonds are unsecured, meaning there is no collateral to back them up, the bonds would likely be considered 'bad paper.'
Why Does Bad Paper Matter?
Bad paper is an extremely risky investment, particularly because it is usually unsecured, meaning there is no collateral for investors to recover if the issuer defaults. However, bad paper is often sold at such a steep discount to face value that any improvement in the issuer's prospects could mean significant profits and above-average interest payments to investors.