Adding VRDOs and VRDNs to your muni bond allocation can help keep duration in check, enhance liquidity, and capture yield increases.
Floating rate, or variable rate securities (VRS), are municipal bond instruments whose interest rates adjust when market conditions change. VRS are generally regraded as attractive when long-term interest rates are relatively high and short-term rates are low in comparison to long-term rates. State and local governments may choose to issue VRS in order to issue long-term debt while taking advantage of short-term rates. Issuing variable-rate debt may translate into lower interest costs over the long term than fixed rate debt at a higher rate.
What are Variable Rate Demand Obligations (VRDOs)?
- Debt instrument that are payable on demand
- May have a fixed interest
- Are part of the short-term muni market, but may have different characteristics
- Do not have a put option and are not redeemable at par
What are Variable Rate Demand Notes (VRDNs)?
- Note that can be redeemed at any time
- Typically accrue interest based on a variable rate
- Often considered a critical asset class in the short-term municipal market
- Have a put option, which allows investors to redeem a bond at par
What Are the Risks of VRDOs?
- Potential credit risk of the issuing municipality and LOC provider.
- Yields can erode as the VRDO’s interest rate periodically resets to the lower prevailing rates in a declining interest-rate environment.
- The issuer can call (retire) the bonds early. Along with the put feature that gives investors the right to sell the bond at par, VRDOs have a call feature, which allows the issuer to call the security at par. This often happens during a period when reset rates become unattractively high and the issuer believes they can secure cheaper funding elsewhere in the market.
VRS Playing Field: VRDOs and VRDNs
Variable Rate Demand Obligations (VRDOs) are long-term floating rate securities that include a put feature allowing the securities to be considered short-term. The interest rates of the securities, which are also known as Variable Rate Demand Notes, are indexed to the SIFMA Municipal Swap Index (SIFMA Index), and the securities are priced at par.
Variable Rate Demand Notes (VRDNs) are tax-exempt debt securities issued by municipalities to secure long-term financing (typically for 20 to 30 years) but at short-term rates. VRDNs trade as short-term municipal money market securities with zero duration.
These distinctions highlight the key differences in interest rate structure, liquidity, and market positioning between VRDOs and VRDNs. Both instruments are designed to provide liquidity, and their specific features vary based on market conditions and investor needs.
The VRDO Opportunity
Extra Stability
VRDOs benefit from a Lett of Credit (LOC) that pledges repayment of principal and interest should the issuer default on the bonds.
Enhanced Liquidity
Investors can sell a VRDO back at par during specified reset periods, ensuring liquidity and aiding in the stability of capital.
Variable Yield
During reset periods, a VRDO’s coupon rate adjusts to the prevailing interest-rate, providing investors with increased levels of interest income.
Gaining Exposure to VRDOs
When interest rates decline, municipal bond (muni) investors search for high yield and longer-dated bonds in a scramble for any extra yield and return. Rather than taking the extra risk of duration and lower quality issues, some seasoned muni investors see VRDOs as an attractive opportunity. But there’s a hook… everyone can’t afford them. The minimum initial buy-in of $100,000 might be too pricey for many individual investors to purchase VRDOs directly. For this reason, active managers with a proven track record of investing across the entire spectrum of municipal bonds may be best able to effectively use VRDOs to deliver the most value to investors, keeping duration and quality in check as interest rates and market dynamics fluctuate.
A large distinction is the re-marketing protection that exists on most VRDOs in the form of a letter of credit (LOC), or standby bond purchase agreements (SBPA). A LOC provides for complete credit substitution, which entails credit and liquidity protection for the issuer. The SBPA provides liquidity or otherwise purchases the bonds in the case of a credit event or failed re-marketing.
VRDNs Explained
VRDNs are long-term taxable or tax-exempt bond that bears a floating interest rate and that provides investors the option to tender or put securities at par on seven days’ notice—or in some cases within a day’s notice. The interest rate on VRDNs fluctuates and resets daily or weekly, depending upon the security and the prevailing money market rate. These securities are designed to meet the needs of investors requiring liquidity, flexibility, and competitive short-term rates.
The reset rate is based on comparable securities with similar maturities and credit ratings, as well as on supply and demand. The investor continually earns the market interest rate because of the reset feature and is guarded against principal loss because of the par tender feature. Bondholders have the right to tender their bonds for payment at par plus accrued interest at any time with appropriate notice to the remarketing agent. In addition, most VRDNs are highly rated due to credit enhancements, which guarantee the principal and interest, as well as the liquidity for bonds tendered.
Key Takeaways
The primary advantages to owning variable rate securities include the potential to lower costs and expenses, hedge a liquidity position, and complete a variable to fixed rate swap. Adding VRDOs or VRDNs to a portfolio can help maintain lower duration while boosting credit quality. And, in certain rate environments, these bonds can provide a boost in tax-exempt yield as their stated yields automatically reset on a daily or weekly basis.
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