Variable Rate Demand Notes (VRDNs): Understanding Floating Rate Debt

A variable rate demand note (VRDN) is a long-term floating rate instrument. It carries an interest rate that accrues periodically in line with the current money markets. From the outset of the loan, the assigned interest rate is equal to the sum of unique money market funds plus an extra margin.

A VRDN is a long-term municipal bondMunicipal BondA municipal bond refers to a bond or fixed income security that is issued by a government municipality, township, or state to finance its governmental, which carries a coupon that adjusts at regular intervals – usually 7 to 35 days – leading to a short-term duration asset. The bonds tendered are then resold to the secondary market by a reseller agent or trustee.

Typically, a VRDN includes a one or seven-day put option that allows investors to put the asset back to an agent to match the notice duration. The long-term bond helps the municipality to borrow funds with long maturities while paying investors short-term rates. It is offered through money market funds, especially to small investors, because it is issued at minimum denominations of $100,000.

Summary

• A variable rate demand note is a debt instrument bearing a floating interest rate that allows an investor to put the stock back to a financial intermediary.
• A variable rate demand note is provided with liquidity funding from banks and other financial institutions with a high credit rating.
• The debt instrument supports the demand note making the credit enhancement an attractive feature for investment.

Understanding Variable Rate Demand Notes

Highly-rated banks and other financial institutions provide VRDNs with liquidity or external credit enhancement support to help put back the asset to an intermediary at par with the notice. The enhancement support allows payment of interest and principal through a letter of credit (LOC).

The issuing agreement requires investors to present a one-day or seven-day notification to enhance the liquidity of the security by tendering to a financial intermediaryFinancial IntermediaryA financial intermediary refers to an institution that acts as a middleman between two parties in order to facilitate a financial transaction. The institutions that are commonly referred to as financial intermediaries include commercial banks, investment banks, mutual funds, and pension funds.. The clear majority of the outstanding VRDNs are held by either municipal money market funds, individual investors, or other investors, such as bond funds and corporations.

One feature of the VRDN is that the debt is payable on demand, courtesy of the embedded put optionEmbedded OptionAn embedded option is a provision in a financial security (typically in bonds) that provides an issuer or holder of the security a certain right but not an obligation to perform some actions at some point in the future. The embedded options exist only as a component of financial security. Lenders or investors can, therefore, request the entire debt amount to be repaid at their discretion. Once the demand’s been made, the funds are fully repaid at a go.

How a VRND Works

The following are the two main elements of a variable rate demand note:

1. Letter of Credit (LOC)

A LOC offers liquidity enhancement and is provided by third-party financial institutions, such as banks. In case the debt instrument includes an irrevocable LOC, the investor’s primary source of credit enhancement is viewed as changed from a municipal issuer to the LOC provider. It happens because, if the issuer cannot pay per to the investor, the LOC issuer can step in as the liquidity provider of last resort.

2. Standby Purchase Agreement (SBPA)

A Standby Purchase Agreement (SBPA) is different from the irrevocable LOC, in that it serves as a conditional liquidity facility for a VRDN. An SBPA can normally be terminated under the following conditions:

• Underlying obligor suffers bankruptcy
• Underlying obligor fails to reach the set investment gradeBond RatingsBond ratings are representations of the creditworthiness of corporate or government bonds. The ratings are published by credit rating agencies and provide evaluations of a bond issuer’s financial strength and capacity to repay the bond’s principal and interest according to the contract.
• Underlying tax-exempt bonds are rendered taxable
• Underlying obligor defaults

In some circumstances, the municipal government is forced to pay for the principle and interest, as well as providing for the par put because a particular VRDN includes neither an LOC nor an SBPA.

Putting Back the Variable Rate Demand Note

After one or seven days of written notice, investors can put their funds into the tender agent. Even so, the marketing resellers take back the VRDN directly from the owner so that it can be put back to a financial intermediary. More often, the resellers try to trade the VRDN within the window period.

At one extreme, an agent never needs to take possession of the VRDN if it is successfully remarketed; at the other, an agent must take the debt instrument into his inventory to facilitate par payment to an investor. Additionally, if the VRDN is not resold, the tender agent then initiates par pay for the notes by drawing on the LOC or SBPA.

The majority of money-making investors seek to select a VRDN whose guarantors are well-capitalized financial institutions. It makes the credit enhancement feature of VRDN an attractive investment option, given that it supports the demand note. In addition to improving the security’s credit rating, the enhancement feature lessens default risks of the underlying securities.

An investor is guaranteed interest payment as long as the banks or financial institutions providing the LOC are solvent. In such regard, the VRDN’s interest rate tends to mimic the short maturity credit profile of the liquidity provider, rather than that of the municipal issuer. Reputable banks may use bond purchase agreements to enhance credit by reducing default risk.

A VRDN bears an interest rate that lowly correlates with bonds and stocks. It makes the debt instrument suitable for investment diversification. While the VRDN can either be taxable or tax-free, municipality governments generally issue variable-rate demands that are tax-exempted by the federal government.

Additional Resources

CFI offers the Capital Markets & Securities Analyst (CMSA)™Program Page - CMSAEnroll in CFI's CMSA® program and become a certified Capital Markets &Securities Analyst. Advance your career with our certification programs and courses. certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Default RiskDefault RiskDefault risk, also called default probability, is the probability that a borrower fails to make full and timely payments of principal and interest,
• Municipal Bond Credit AnalysisMunicipal Bond Credit AnalysisMunicipal bond credit analysis involves evaluating a municipal bond to determine its viability as an investment opportunity. A municipal bond is a type of
• Net Interest Rate SpreadNet Interest Rate SpreadNet interest rate spread refers to the difference between the interest rate a financial institution pays to depositors and the interest rate it receives
• SolvencySolvencySolvency is the ability of a company to meet its long-term financial obligations. When analysts wish to know more about the solvency of a company, they look at the total value of its assets compared to the total liabilities held.