What is 'Tax-Exempt Commercial Paper'

A tax-exempt commercial paper is a short-term unsecured loan, usually issued to finance short-term liabilities, which provides the debt holders, or bondholders with some level of tax preference on their debt investment's earnings. Choices may be taken on local, state, federal, or a combination of taxes. The tax-exempt commercial paper is issued with a fixed interest rate and must mature in less than 270 days. Commercial paper is usually in increments of $1,000.

BREAKING DOWN 'Tax-Exempt Commercial Paper'

Commercial paper is mostly a promissory note backed by the financial intuition's health. No federal government policy covers losses incurred from commercial paper. The Federal Deposit Insurance Company (FDIC) does not insure against losses from investing in a tax-exempt commercial paper. An investor can ensure the commercial paper's safety by checking the ratings listed by rating agencies such as Standard & Poor's or Moody's

Because of default risk and timeliness issues, interest rates on commercial paper are typically higher than other short-term cash instruments. Tax-exempt commercial paper interest rates increase as the economy grows.

Buyers and Sellers of Tax-Free Commercial Paper

The tax-exempt commercial paper is beneficial for issuers. Interest rates on tax-exempt debt are lower than taxable debt. Likewise, the tax-exempt paper is potentially helpful for purchasers. The effective interest rate may be higher than other taxable commercial paper.

A tax-exempt commercial paper issued by the government results in government support of specific entities or institutions. Instead of the government directly funding the institution, the government will forgo the collection of taxes on the interest income. Thus, a tax-exempt commercial paper is an instrument of public policy with the replacement of financial support replaced by the lost tax income.

Only companies with an investment-grade rating may issue commercial paper. Corporations and governments typically issue tax-exempt commercial paper, while banks, mutual funds, or brokerage firms buy the tax-exempt commercial paper. These institutions 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 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.

Tax-Free Commercial Paper Interest Rates

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 Monday. Information relating to the total amount of outstanding paper issued is also released once per week.

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