What Is a Variable-Rate Demand Bond?
Let me explain what a variable-rate demand bond is—it's a type of municipal bond, or muni, that comes with floating coupon payments adjusted at specific intervals. You, as the bondholder, can demand payment on the bond following an interest rate change. Typically, the interest rate is set based on the current money market rate, plus or minus a fixed percentage, which means your coupon payments could change over time.
Key Takeaways
To sum it up directly, a variable-rate demand bond is a municipal bond with floating coupon payments that get adjusted at set intervals. Municipal bonds are what state and local governments issue to raise money for big public projects. Compared to standard municipal bonds, these demand bonds bring more uncertainty due to their floating rates, but you can mitigate some of that risk through options like redemption.
Understanding Variable-Rate Demand Bonds
Even though you can redeem a demand bond anytime, issuers often encourage you to hold onto them to keep receiving those coupon payments. The floating rate does add uncertainty to your cash flows compared to regular municipal bonds, but the redemption option helps offset some risk.
Municipal bonds get issued by state and local governments to fund projects like hospitals, highways, and schools. In exchange for your investment, you get periodic interest payments as coupons until the bond matures, at which point the issuer repays the face value.
Some munis have fixed coupons, but others are variable—those are the variable-rate demand bonds. Their interest rates reset daily, weekly, or monthly, and they're issued for long-term financing, with maturities from 20 to 30 years.
These bonds also need liquidity support if remarketing fails. That could come from a letter of credit, a standby bond purchase agreement, or self-liquidity, making them suitable for money market funds.
For example, a letter of credit is an unconditional promise from a bank to pay you the principal and interest if the issuer defaults, goes bankrupt, or gets downgraded. As long as that bank stays solvent, you'll get your payment.
The Early Redemption Option
Variable-rate demand bonds often include an embedded put feature, letting you tender the bonds back to the issuer on the interest reset date. The put price is par plus any accrued interest. You have to notify the tender agent a certain number of days in advance of the tender date.
You'd typically exercise this put if you need immediate access to your funds or if market rates have risen so much that the bond's current coupon isn't appealing anymore.
If you tender the bond early due to rising rates, the remarketing agent sets a new, higher rate. If rates fall below the coupon, the agent resets to the lowest rate that prevents a put from being exercised.
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