What Is a Variable Rate Demand Obligation?
A variable rate demand obligation (VRDO) is a type of long-term debt instrument that offers investors a short-term, floating rate of interest and the unique ability to "put" or tender the bond back to the issuer or a designated agent at par value, typically with a short notice period (e.g., daily or weekly). Belonging to the broader category of fixed-income securities, VRDOs are often issued by state and local governments, making them a common form of municipal bond. This demand feature provides investors with significant liquidity despite the bond's underlying long-term maturity.
History and Origin
The evolution of municipal finance has seen innovations designed to meet both issuers' funding needs and investors' preferences. Variable rate demand obligations gained prominence as a flexible financing tool, particularly for public projects requiring long-term capital while allowing issuers to potentially benefit from lower short-term interest rate environments. A significant development in the oversight of these securities occurred when the U.S. Securities and Exchange Commission (SEC) approved amendments to Rule 15c2-12 in May 2010. These amendments expanded the scope of disclosure requirements to include new issuances of variable rate demand obligations, aiming to enhance transparency in the municipal securities market. Prior to these changes, certain VRDOs were exempt from the rule's continuing disclosure provisions.6 The amendments mandated that underwriters reasonably determine that the issuer has agreed to provide ongoing disclosure of certain events, including those affecting VRDOs, within a timely manner.5
Key Takeaways
- Variable rate demand obligations are long-term bonds with short-term interest rate resets, typically daily or weekly.
- They provide investors with a "put option," allowing them to sell the bond back at par, ensuring high liquidity.
- VRDOs are commonly issued by municipal entities to finance public projects.
- Their interest rates adjust periodically, reflecting current market conditions, which can lead to fluctuating income for investors.
- A remarketing agent is responsible for reselling tendered VRDOs, often supported by a liquidity facility.
Interpreting the Variable Rate Demand Obligation
The defining characteristic of a variable rate demand obligation is its put option, which allows the bondholder to demand repayment of the principal amount at specified intervals, usually daily or weekly. This feature effectively transforms a long-term bond into a short-term liquid asset from the investor's perspective, as the investor can exit the investment at par plus accrued interest if desired. The interest rate on a VRDO is reset periodically by a remarketing agent, based on prevailing money market rates. This reset mechanism means that the income generated by a VRDO fluctuates with market interest rates. Investors considering VRDOs should understand that while the put feature mitigates price risk, their income stream is not fixed and will vary.
Hypothetical Example
Imagine the City of Metropolis issues a $10 million variable rate demand obligation to finance a new public transportation project. The VRDO has a stated long-term maturity of 30 years but features a weekly interest rate reset and a corresponding weekly put option.
An investor purchases $100,000 of this VRDO. For the first week, the remarketing agent sets the interest rate at 2.5%. The investor earns interest based on this rate for that week. At the end of the week, the rate is reset. If the investor is content with the new rate or simply wishes to continue holding the bond, they do nothing. However, if the investor needs access to their funds or is dissatisfied with the newly set rate, they can exercise their put option by providing the required notice (e.g., one day). Upon tendering, the bond is redeemed at its face value ($100,000) plus any accrued interest. The remarketing agent then attempts to resell the tendered VRDO to another investor at the newly reset rate. If the bond cannot be remarketed, a third-party liquidity provider (like a bank providing a letter of credit) is obligated to purchase the bond, ensuring the investor receives their principal.
Practical Applications
Variable rate demand obligations are widely used in the municipal bond market by state and local governments seeking flexible, long-term financing at short-term rates. For issuers, VRDOs can offer lower borrowing costs compared to traditional fixed-rate long-term debt when short-term interest rates are low. For investors, particularly institutional investors like money market funds, VRDOs are attractive because they offer tax-exempt income (if issued by qualifying municipalities) coupled with daily or weekly liquidity due to the demand feature.
The Municipal Securities Rulemaking Board (MSRB) plays a crucial role in regulating VRDOs by establishing rules for municipal securities dealers and remarketing agents. For instance, MSRB Rule G-34 outlines requirements for CUSIP numbers, new issue information, and the submission of documents related to VRDOs, ensuring transparency and market information availability.4 The underlying interest rate for VRDOs is often tied to short-term money market indices, meaning their yields are directly influenced by broader monetary policy decisions, such as those made by the Federal Reserve.
Limitations and Criticisms
Despite their benefits, variable rate demand obligations come with certain limitations and risks. For investors, while the put option provides liquidity, the floating interest rate introduces uncertainty regarding future income. In a declining interest rate environment, the yield on VRDOs will erode as their rates periodically reset to lower prevailing levels.3 Conversely, in a rapidly rising interest rate environment, the remarketing agent might struggle to find new buyers for tendered bonds at the current rate, potentially leading to a "failed remarketing." While a liquidity facility (such as a letter of credit or standby bond purchase agreement) typically guarantees payment to the tendering investor, a reliance on the solvency and commitment of the liquidity provider introduces an additional layer of credit rating risk.2 For the issuer, a failed remarketing can result in the VRDOs being purchased by the liquidity provider, converting them into "bank bonds" with potentially higher, less favorable interest rates for the municipality. Furthermore, VRDOs are typically issued in large denominations (e.g., $100,000 or more), making them less accessible for most individual investors to purchase directly.1
Variable Rate Demand Obligation vs. Tender Option Bond
While both are types of municipal bonds offering variable rates and liquidity, a Variable Rate Demand Obligation (VRDO) and a Tender Option Bond (TOB) differ primarily in their structure and the role of the investor's "put" right.
A Variable Rate Demand Obligation (VRDO) is a single bond where the investor has the direct contractual right to tender the bond back to the issuer (or its agent) at par on specified reset dates. The variable rate is applied directly to this single security.
A Tender Option Bond (TOB), on the other hand, is a structured finance vehicle created from a fixed-rate municipal bond. A trust or special purpose vehicle acquires a fixed-rate bond and then issues two new securities: a short-term, variable-rate bond (often called a "floating-rate receipt" or "tender option bond") and a long-term, inverse floating-rate bond (often called an "inverse floater" or "residual interest bond"). The variable-rate component of a TOB is designed to mimic the liquidity and variable rate characteristics of a VRDO, but it's derived from a repackaging of a different underlying security, not an inherent feature of the original bond itself. The liquidity mechanism for the variable-rate TOB component relies on the TOB trust, which in turn often uses a liquidity provider.
In essence, a VRDO is a standalone debt instrument with a built-in demand feature, while a TOB is a synthetic structure that creates a variable-rate, puttable security from an existing fixed-rate bond, alongside an inverse-floater.
FAQs
Who typically invests in Variable Rate Demand Obligations?
Due to their high minimum denominations (often $100,000 or more), VRDOs are primarily purchased by institutional investors such as money market funds, mutual funds, and large corporations that seek tax-exempt income combined with high liquidity. Individual investors typically gain exposure to VRDOs indirectly through these funds.
How is the interest rate on a VRDO determined?
The interest rate on a variable rate demand obligation is typically reset periodically—daily or weekly—by a remarketing agent. This rate is usually tied to a short-term money market index, such as the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index, plus or minus a certain spread.
What happens if an investor tenders their VRDO and it cannot be remarketed?
If a VRDO is tendered by an investor and the remarketing agent cannot find a new buyer, the bond will typically be purchased by a third-party liquidity provider. This provider, usually a commercial bank that has issued a letter of credit or standby bond purchase agreement, is contractually obligated to buy the tendered bonds, ensuring the investor receives their principal. These bonds then become "bank bonds" and may accrue interest at a penalty rate until they can be remarketed or refinanced by the issuer.
Are Variable Rate Demand Obligations always tax-exempt?
Not necessarily. While many variable rate demand obligations are issued by state and local governments and structured to provide tax-exempt interest income at the federal level, and sometimes at the state and local levels for residents of the issuing state, their tax status depends on the specific bond and the purpose for which it was issued. Investors should always verify the tax implications of any specific VRDO.