What Is a Variable Rate Demand Note?

What Is a Variable Rate Demand Note?

Let me explain what a variable rate demand note, or VRDN, really is. It's a debt instrument where you borrow funds that are payable on demand, and the interest accrues based on a current money market rate like the prime rate. From the start, the interest rate is set as that money market rate plus an extra margin. You might also hear it called a variable rate demand obligation, or VRDO.

Key Takeaways

Here's what you need to know right away. A variable rate demand note is a debt instrument with an interest rate that changes over time. That rate ties directly to a set money market benchmark, such as the prime rate. Municipal governments use these to secure long-term capital. And typically, VRDNs come in denominations of $100,000 or more, which puts them out of reach for most individual investors.

Understanding Variable Rate Demand Note (VRDN)

Think of a VRDN as a long-term municipal bond that investors access through money market funds. These notes let municipal governments borrow money for extended periods while only paying short-term interest rates to you, the investor. Since they're issued in at least $100,000 chunks, smaller investors like you can only get in indirectly via money market funds.

Money market rates, like the bank prime rate, fluctuate, so the interest on a VRDN does too. Whenever the prevailing rate shifts, the VRDN's rate adjusts to match. Usually, this happens daily, weekly, or monthly to stay in line with the current environment. According to BlackRock, these variable rate demand obligations make up about 76% of securities in money market funds.

Characteristics of Variable Rate Demand Obligations

As the name suggests, these notes are payable on demand because they include an embedded put option. That means you, as the investor or lender, can demand repayment of the full amount whenever you want, and it has to be paid once requested. Depending on the specific demand terms, you might need to give a one-day or seven-day notice to a financial intermediary like a trustee or remarketing agent. Because of this feature, the maturity date for a VRDN is seen as the next put date, not the final one.

Another key aspect that draws money market investors is the credit enhancement backing the note. This is a feature that boosts the security's credit profile and cuts down on default risk. Issuers use things like letters of credit from highly rated banks, which act as the last-resort liquidity provider to ensure timely interest payments and principal repayment on tendered securities. As long as that bank stays solvent, you'll get your payment.

That's why the interest rate on VRDNs often mirrors the short-term credit rating of the bank providing the letter of credit, not the issuing municipality. Another option for enhancement is a standby bond purchase agreement from a solid bank. These notes also offer returns with low correlations to stocks and bonds, making them useful for diversifying your portfolio. Plus, municipal VRDNs are usually exempt from federal taxes, and many from state taxes in the issuing state.

Can You Invest in Variable Rate Demand Obligations?

These obligations typically require a minimum investment of $100,000, so they're not practical for most individual investors like you. But you can still get exposure by purchasing shares in a mutual fund that focuses on municipal securities.

How Are Variable Rate Demand Obligations Taxed?

Just like other municipal bonds, the interest from VRDNs is generally exempt from federal taxes, and sometimes state taxes too. This comes with strict IRS requirements that they must meet.

How Are Variable Rate Demand Obligations Redeemed?

These notes include a put feature that lets you redeem them before maturity. You can exercise this at set intervals, often when interest rates reset. If you do, the bonds are usually remarketed to another investor. If no buyer is found, it's a failed remarketing, and the bonds go to a prearranged financial institution. VRDOs come with a liquidity facility from a bank to handle this situation and ensure liquidity.

The Bottom Line

In summary, variable rate demand notes are municipal bonds with floating interest rates that enable city and state governments to borrow over long terms. You can access them mostly through money market or municipal bond funds. Issuers team up with big financial institutions for credit and liquidity support, which helps them borrow at lower rates.