Key Takeaways
- Long-term bonds with floating interest rates.
- Investors can sell bonds back on demand.
- Interest rates reset periodically based on benchmarks.
- Often backed by credit or liquidity enhancements.
What is Variable-Rate Demand Bond?
A Variable-Rate Demand Bond (VRDB) is a long-term municipal bond with an interest rate that resets periodically and includes a put option allowing investors to sell back the bond at face value on demand. This structure offers issuers the advantage of borrowing long-term at short-term rates, while investors benefit from liquidity and floating yields.
Also known as Variable-Rate Demand Obligations (VRDOs), these bonds are popular in municipal finance and often feature credit enhancements such as letters of credit to support timely payments.
Key Characteristics
VRDBs combine features of short-term and long-term debt to meet both issuer and investor needs:
- Floating Interest Rate: Resets regularly, often weekly or monthly, based on benchmarks like the SIFMA Municipal Swap Index, ensuring yields track current market rates.
- Put Option: Investors can demand redemption at face value with short notice, providing exceptional liquidity uncommon in traditional bonds.
- Remarketing Agent: Responsible for reselling tendered bonds to new investors, maintaining continuous marketability.
- Credit Enhancements: Instruments such as back-to-back letters of credit often support the bonds, reducing credit risk for investors.
- Target Investors: Typically issued in large denominations, attracting institutional buyers including money market funds.
How It Works
Issuers sell VRDBs to finance projects with maturities that can span decades, while interest rates reset frequently to align with short-term market conditions. At each reset date, the remarketing agent sets the new rate reflecting current benchmarks, influencing the bond’s yield.
If investors find the rate unattractive, they may invoke the put option, demanding the bond be repurchased at face value. The remarketing agent then resells the bond to new buyers, often supported by credit facilities. This mechanism keeps the effective duration short, resembling money market instruments despite the long maturity.
Examples and Use Cases
Variable-Rate Demand Bonds are widely used by municipalities and sectors requiring long-term capital at flexible rates:
- Municipalities: Cities issue VRDBs for infrastructure projects, leveraging floating rates to reduce interest costs over time.
- Airlines: Companies like Delta may use similar variable-rate instruments in their debt portfolios to match cash flow needs.
- Bond Investors: Those seeking tax-exempt income often consider VRDBs, which can complement holdings such as bond funds or align with strategies in best bond ETFs.
Important Considerations
While VRDBs offer attractive liquidity and interest rate flexibility, investors should assess the credit quality of both the issuer and any credit enhancers. Failed remarketing or enhancer insolvency can impact liquidity and returns.
Understanding the bond’s effective duration, often measured by metrics like Macaulay duration, helps you evaluate interest rate risk. Additionally, the complexity of the demand feature means these bonds may not suit all retail investors due to minimum denominations and potential market disruptions.
Final Words
Variable-Rate Demand Bonds offer flexible, short-term rate exposure with liquidity protections, making them attractive for both issuers and investors. Evaluate current market conditions and credit support structures before considering VRDBs to ensure they align with your risk tolerance and investment goals.
Frequently Asked Questions
A Variable-Rate Demand Bond is a long-term municipal bond with a floating interest rate that resets periodically and includes a 'put' option allowing investors to sell the bond back at par value on demand. This structure offers issuers long-term funding at short-term rates while providing investors with liquidity and protection against interest rate changes.
The interest rate on a VRDB resets periodically, typically daily, weekly, or monthly, based on benchmarks like the SIFMA Municipal Swap Index plus a margin. This reset aligns with scheduled tender dates, allowing the bond’s yield to adjust with current market conditions.
The 'put' option gives investors the right to sell their bonds back to the issuer or a designated agent at par value with short notice, usually 1 or 7 days. This feature provides investors with high liquidity and reduces the effective duration of the bond despite its long maturity.
VRDBs are primarily purchased by institutional investors such as money market funds, which make up about 76% of their holdings. These investors value the bonds for their tax-exempt status, liquidity, and floating-rate protection.
Remarketing agents resell tendered bonds at par value to maintain liquidity for investors. They also set the floating interest rates at each reset period based on market conditions to ensure the bonds remain attractive to buyers.
VRDBs often have credit or liquidity enhancements like Letters of Credit from banks or Standby Purchase Agreements that guarantee timely principal and interest payments. These enhancements shift credit risk to higher-rated entities, improving investor confidence and bond marketability.
Issuers benefit from borrowing long-term at short-term rates with refinancing flexibility, but they face risks like sudden interest rate spikes and reliance on successful remarketing. Additionally, fees for credit or liquidity enhancements can increase borrowing costs.
VRDBs usually have high minimum denominations, typically $100,000, making them more suitable for institutional buyers rather than individual investors. This minimum size helps maintain liquidity and efficient remarketing.
