Variable Rate Demand Obligations

What are Variable Rate Demand Obligations?

Variable rate demand obligations (VRDOs) are debt instruments that provide a steady interest income stream while allowing the interest rate to fluctuate based on changes in a specified benchmark or reference rate. They are highly flexible and offer investors the option to demand and accrue interest at specific intervals, typically one or seven days. These obligations are often issued by municipal governments as a form of long-term financing, and they are usually backed by credit enhancement such as a letter of credit or a standby purchase agreement from highly rated banks, providing investors with protection against default risk.

Variable Rate Demand Obligations Explained

Variable rate demand obligations (VRDOs) are a type of debt securities issued by municipal governments in the United States. These securities offer a unique feature of having their interest rates adjusted by a remarketing agent at specific intervals, such as daily, weekly, or monthly, which may differ from the frequency of coupon payments. VRDOs, often referred to as variable rate demand notes, provide investors with a steady interest income stream.

Typically, VRDOs have a long maturity period ranging from 10 to 30 years, providing municipal issuers with long-term financing options. One attractive aspect of VRDOs is their tax-exempt status, making them appealing to individual investors and money market funds seeking tax-efficient investments.

The interest rate adjustment process and frequency are outlined in official documents governing the VRDO issuance. These bonds usually have a high minimum investment threshold, typically starting at $100,000. Holders of VRDOs have the option to present them to the issuer for purchase or redemption on the date of the interest rate adjustment. The price of the put option is typically the face value of the bond plus any accrued interest.

VRDOs are commonly traded as short-term municipal papers with a duration of zero, providing investors with liquidity and flexibility. They are often considered a stable investment option due to their tax-exempt status and the backing of municipal governments.

Advantages and Disadvantages

Advantages

• Extra Stability. VRDOs benefit from a Letter of Credit (LOC) provided by well-capitalized financial institutions, pledging repayment of principal and interest in case of issuer default, enhancing investor confidence in the security of their investment.

• Enhanced Liquidity. Investors have the option to sell VRDOs back at par during specified reset periods, ensuring liquidity and providing a mechanism for maintaining stable capital.

• Variable Yield. VRDOs offer a flexible coupon rate that adjusts to prevailing interest-rate levels during reset daily periods, potentially providing investors with increased interest income during periods of rising rates.

Disadvantages

• Potential Credit Risk. Despite the presence of a LOC, there remains the possibility of credit risk associated with both the issuing municipality and the LOC provider, which could impact the security of the investment.

• Yield Erosion. In a scenario where interest rates decline, the yields on VRDOs may decrease as the coupon rate resets to lower prevailing rates, potentially leading to reduced income for investors.

• Call Feature. VRDOs may be subject to early redemption by the issuer through a call feature, allowing the issuer to retire the bonds at par. This typically occurs when reset rates become unattractively high for the issuer, potentially resulting in the loss of higher-yielding investment opportunities for investors.

Classes of VRDOs

1. Lower Floater. This is the most common form of VRDO, where the interest rate is adjusted weekly based on a specified index. Bondholders typically need to provide the issuer with seven days' notice if they wish to exercise their put option, allowing them to sell the bonds back to the issuer.

2. Longer-Term VRDOs. These VRDOs have a longer maturity period and allow the coupon rate to be reset monthly or quarterly, offering investors more flexibility in their investment strategy.

3. Flexible Put Options. Some VRDOs allow bondholders to exercise their put option at any time, providing them with greater liquidity and control over their investment. However, others may only permit the put option to be exercised on the interest adjustment date, limiting the flexibility of investors.

Example

The City of New York issues $100 million in VRDOs with a 29-year maturity. The VRDOs have interest rates that reset weekly based on a benchmark rate. A remarketing agent is appointed to conduct the periodic sales and interest rate resets, most commonly investment banks such as Morgan Stanley, Bank of America, Barclays and etc.

Suppose in week 1 the remarketing agent set the rate at 1.2%, in week 2 the rate is already 1.5%, in week 3 the rate is 1.4%, in week 4 the rate is 1.7%. Coupon frequently is monthly. To determine the coupon payment, a weighted average rate will be calculated.

To determine the weekly interest rates as annual rates, find the weekly rate, divide the annual rate by 52.

1 week: 1.2%/52 = 0.02308%.

2 week: 1.5%/52 = 0.02885%.

3 week: 1.4%/52 = 0.02692%.

4 week: 1.7%/52 = 0.03269%.

Total monthly interest = 0.02308% + 0.02885% + 0.02692% + 0.03269% = 0.1115%. In the case of an investor purchasing a VRDO for $100,000, the monthly coupon payment would be $1,115.