What Is Tax-Exempt Commercial Paper?

Tax-exempt commercial paper is short-term unsecured debt where the bondholder does not pay federal, state, or local taxes on the interest payments.

Key Takeaways

  • Tax-exempt commercial paper is short-term unsecured debt where the bondholder does not pay federal, state, or local taxes on the interest payments.
  • Tax-exempt commercial paper is issued with a fixed interest rate, has a maturity date of fewer than 270 days, and is commonly denominated in increments of $1,000.
  • Interest rates on tax-exempt commercial paper are typically higher than other short-term cash instruments but will be lower than taxable debt.

Understanding Tax-Exempt Commercial Paper

Tax-exempt commercial paper is usually issued to finance short-term liabilities, which provides the debt holders (bondholders) with some level of tax preference on their debt investment earnings. Tax-exempt commercial paper is issued with a fixed interest rate, has a maturity date of fewer than 270 days, and is commonly denominated in increments of $1,000.

Commercial paper is mostly a promissory note backed by the financial intuition's health. Federal government policy does not cover losses incurred from investing in commercial paper. Furthermore, the Federal Deposit Insurance Company (FDIC) does not insure against losses from investing in tax-exempt commercial paper. An investor's due diligence should include checking the desired tax-exempt commercial paper's quality ratings listed by agencies such as Standard & Poor's or Moody's

Given the probability of default risk and timeliness issues, interest rates on tax-exempt commercial paper are typically higher than other short-term cash instruments. Conversely, tax-exempt commercial paper interest rates will be lower than taxable debt. Additionally, tax-exempt commercial paper interest rates should rise as the economy grows.

Tax-exempt commercial paper issued by the government is an indirect method of support for those specific entities as opposed to directly funding these entities. The government forgoes the collection of taxes on the interest income, but the logic is that the entity issuing the tax-exempt commercial paper will engage in activities that serve the community that will end up generating more value than the lost tax revenue. Thus, tax-exempt commercial paper can be viewed as an instrument of public policy.

Only companies with an investment-grade rating may issue commercial paper. Institutions, such as universities and governments, typically issue tax-exempt commercial paper, while banks, mutual funds, or brokerage firms buy the tax-exempt commercial paper. The buyers may hold the commercial paper as an investment or act as an intermediary and resell the investment to their customers. There is a limited market for tax-exempt commercial paper issued directly to smaller investors. Due to the 2008 financial recession, new legislation limits the type and amount of commercial paper held in money market funds.

The Federal Reserve Board (FRB) publishes current borrowing rates on commercial paper on its website. The FRB also publishes the rates of highly rated commercial paper in a statistical release occurring each Friday. Information relating to the total amount of outstanding paper issued is also released once per week.

Tax-Exempt Commercial Paper Benefits

The tax-exempt commercial paper is beneficial for the borrower (issuer) as they are able to access funds at lower rates than they might otherwise have to pay if they had borrowed the money from a traditional financial institution, such as a bank. Tax-exempt commercial paper can be beneficial for the lender (bond buyer) as the net rate of return may end up being higher than if they had invested in taxable commercial paper.