Variable Rate Demand Obligations

Variable Rate Demand Obligations (VRDO) is a type of US municipal bonds with floating coupon payments, the rate for which is reset at certain intervals (day, week, month), which most often do not correspond to the frequency of payments of accumulated coupon income. Such bonds are issued by state and local governments to provide long-term financing for a period of 20 to 30 years and they are not subject to taxation.

As a rule, the period for adjusting the VRDO interest rate and the process for determining it are set in official documents. Also, such bonds have a high minimum investment threshold of $100,000 and can be presented by bondholders to the issuer on the date of the interest rate adjustment. The price of the put option in this case will be face value plus accrued interest. Such bonds are traded as short-term municipal papers with zero duration.

Benefits of Variable Rate Demand Bonds:

1. VRDOs guarantee the payment of principal and interest in the event of an issuer’s default, since the vast majority of such bonds are secured by bank letters of credit (Letter of Credit (LoC)) to increase the creditworthiness of the issuer;
2. The ability to sell the bond at par during the interest rate adjustment period provides additional liquidity to the bonds.

Disadvantages of Variable Rate Demand Bonds:

1. The issuer’s ability to early redeem bonds at par at a time when the adjusted interest rate becomes unattractively high.
2. Reduced bond yields due to frequent adjustments in interest rates.

Example: Burke Development Authority, FRN 1jan2040, USD