Variable rate demand obligations (VRDOs) are a type of long-term bond that features a short-term, floating interest rate and a put option that allows investors to demand repayment of the principal amount on short notice, typically daily or weekly. These instruments are a significant component of the Fixed Income market, primarily used by municipal bonds issuers to finance long-term projects while benefiting from lower short-term interest rates. The unique structure of VRDOs aims to provide investors with liquidity while offering issuers access to cost-effective debt financing.
History and Origin
The development of variable rate demand obligations emerged from the need for long-term financing instruments that could appeal to investors seeking short-term liquidity. Their popularity grew significantly from the 1970s onward, particularly within the municipal bond market, as issuers sought to take advantage of potentially lower short-term borrowing costs compared to fixed-rate, long-term debt. A key feature that allowed VRDOs to thrive was the integration of a tender option and a liquidity facility, which ensured investors could redeem their bonds at par.
The structure of VRDOs allowed states and municipalities to fund substantial infrastructure and public works projects while providing investors with a seemingly secure and highly liquid investment. However, the stability of the VRDO market was severely tested during the 2008 financial crisis. The crisis exposed vulnerabilities in the liquidity facilities that underpinned many VRDOs, as financial institutions providing these facilities faced their own solvency issues. This led to a significant increase in interest rates on these obligations and substantial challenges for issuers unable to remarket their bonds or secure new liquidity support. For instance, in February 2008, the municipal bond market experienced a chill as liquidity providers struggled, impacting counties and hospitals.12 The Federal Reserve Bank of San Francisco later published an economic letter examining the market for variable-rate demand obligations, highlighting their structure and the issues faced during periods of market stress.11
Key Takeaways
- Variable rate demand obligations (VRDOs) are long-term bonds with short-term, floating interest rates and a tender (put) option.
- They are predominantly issued by state and local governments to finance public projects.
- VRDOs offer investors liquidity because they can be "put" back to the issuer at par on specified reset dates, typically daily or weekly.
- A crucial component of VRDOs is a liquidity support agreement, often a letter of credit or standby bond purchase agreement from a bank, which ensures repayment if the bonds cannot be remarketed.
- The interest rate on VRDOs is periodically reset by a remarketing agent based on market conditions.
Interpreting the Variable Rate Demand Obligations
Variable rate demand obligations are interpreted primarily by their current floating rate and the strength of their underlying credit rating and liquidity support. For investors, the appeal lies in the ability to hold a long-term bond that behaves like a short-term instrument due to the frequent interest rate resets and the demand feature. This means that as general market interest rates rise or fall, the interest rate paid on the VRDO adjusts accordingly, aiming to keep its market price at or near par.
The quality of the liquidity provider (typically a bank that issues a letter of credit or standby bond purchase agreement) is paramount. If a VRDO cannot be remarketed to a new investor, the liquidity provider is obligated to purchase the bonds. Therefore, the financial health and credit rating of this third-party provider significantly influence the perceived safety and tradability of the VRDO. Changes in the liquidity provider's creditworthiness can directly impact the VRDO's market value, even if the issuer's own credit remains strong. Investors closely monitor the current interest rate, reset frequency (daily, weekly, or monthly), and the identity and rating of the liquidity provider.
Hypothetical Example
Consider the City of Harmony, which needs to finance a new wastewater treatment plant requiring $50 million. Instead of issuing traditional fixed-rate municipal bonds, the city's financial advisors recommend issuing $50 million in Variable Rate Demand Obligations with a 30-year final maturity but a weekly interest rate reset and a weekly tender option.
An investor, Jane, purchases $100,000 of these VRDOs. For the first week, the interest rate is set at 2.5%. At the end of the week, a remarketing agent resets the rate based on current market conditions. If Jane is satisfied with the new rate (e.g., 2.6%) and continues to hold the bond, she keeps it. However, if she needs her capital back or is unhappy with the new rate, she can "tender" her bonds back to the remarketing agent at par value (plus accrued interest). The remarketing agent then attempts to resell these bonds to another investor. If a new buyer isn't immediately found, a standby bank (the liquidity provider) steps in and purchases the bonds, ensuring Jane receives her $100,000. This mechanism allows the City of Harmony to maintain its long-term financing while offering investors short-term liquidity.
Practical Applications
Variable rate demand obligations are primarily utilized by state and local governments as a flexible tool for capital improvements and public infrastructure projects. Their structure allows these entities to potentially lower their overall debt costs by borrowing at short-term rates, which are historically lower than long-term rates. For issuers, VRDOs provide flexibility; they can often convert the variable rate to a fixed rate if market conditions become unfavorable or if long-term rates decline significantly.
On the investor side, VRDOs are often attractive to institutional investors, such as money market funds, corporations, and high-net-worth individuals, who prioritize liquidity and capital preservation. Because the interest rate resets frequently, these investors can earn a market-responsive yield while retaining the ability to redeem their principal on short notice. The tax-exempt nature of many municipal bonds, including VRDOs, adds to their appeal for certain investors seeking income advantages. The Municipal Securities Rulemaking Board (MSRB) provides extensive information and data on VRDOs, highlighting their role and characteristics within the municipal securities market.10 Additionally, the Securities and Exchange Commission (SEC) has brought enforcement actions related to sales practice violations by underwriters of VRDOs, underscoring the regulatory oversight in this market segment.9
Limitations and Criticisms
Despite their advantages, variable rate demand obligations carry specific investment risk and have faced criticisms, particularly concerning their liquidity mechanisms during stressed market conditions. A primary concern is "remarketing risk," which arises if the remarketing agent cannot find new buyers for tendered bonds. While a liquidity provider is typically in place to purchase these bonds, reliance on such facilities introduces "liquidity provider risk." If the financial health or credit rating of the liquidity provider deteriorates, it can undermine investor confidence and potentially lead to a higher interest rate on the VRDOs or even a failed tender.
The 2008 financial crisis brought these limitations into sharp focus, as the stability of the entire VRDO market was jeopardized by problems with bond insurers and liquidity providers. Many issuers found themselves forced to pay much higher rates or undertake costly refinancing to convert their VRDOs to fixed-rate debt. While structural enhancements and increased regulatory scrutiny have been implemented since then, the inherent reliance on a robust financial system and reliable third-party liquidity support remains a critical consideration. The Federal Reserve Bank of San Francisco discussed how VRDOs faced elevated yields during the global financial crisis due to increased liquidity risk premiums, contrasting with the response to later crises where support facilities were put in place.8
Variable Rate Demand Obligations vs. Auction Rate Securities
Variable Rate Demand Obligations (VRDOs) are often confused with Auction Rate Securities (ARS) due to their shared characteristic of variable interest rates and mechanisms for liquidity. However, their fundamental differences lie in how their rates are reset and how liquidity is provided.
VRDOs feature a tender option, or put option, allowing investors to directly demand repayment from the issuer (through a remarketing agent and often a liquidity provider) on the interest rate reset date, typically daily or weekly. This mechanism provides a direct and explicit path to liquidity at par.
Conversely, Auction Rate Securities relied on a periodic auction process to reset their interest rates and facilitate liquidity. Investors who wished to sell their ARS would place sell orders in an auction, hoping that there would be enough buyers to clear the market. The critical flaw exposed during the 2008 financial crisis was the failure of these auctions when buyers disappeared, leaving investors with illiquid securities. Unlike VRDOs, ARS generally lacked a direct, third-party liquidity facility that would step in if an auction failed, leading to widespread market collapse for ARS. The MSRB has tracked the decline of ARS, noting it is "no longer a significant part of the municipal bond market."7
FAQs
What is the primary benefit of Variable Rate Demand Obligations for investors?
The primary benefit for investors in variable rate demand obligations is the combination of a long-term bond with the liquidity of a short-term instrument. Investors can redeem their bonds at par on short notice (e.g., daily or weekly) while earning a floating rate of interest that adjusts to market conditions.
How is the interest rate on a VRDO determined?
The interest rate on a variable rate demand obligation is typically reset periodically—daily, weekly, or monthly—by a remarketing agent. This rate is determined based on prevailing market conditions, including short-term interest rates for comparable securities, supply, and demand for the specific VRDO.
What happens if a VRDO cannot be remarketed?
If a variable rate demand obligation cannot be remarketed to a new investor when tendered by a holder, a pre-arranged liquidity facility (usually a bank-issued letter of credit or standby bond purchase agreement) steps in to purchase the bonds. This ensures that the investor receives their principal and accrued interest, maintaining the bond's short-term nature and its ability to be "put" back to the issuer. This mechanism is crucial for mitigating investment risk.123456