August 28, 2018
Variable rate demand notes (VRDNs) are floating-rate debt securities issued by municipalities and are most often held in municipal money-market funds. Like other municipal debt, most VRDNs are not taxed at the federal level, and residents of issuing states are generally exempt from relevant state taxes. In general, VRDNs have three key characteristics that distinguish them from other municipal bonds: they have variable rates, they come with a put option, and they often have liquidity and credit support from a third-party financial institution.
Variable rates allow investors to earn the prevailing market yield while reducing the risks associated with rising interest rates. While VRDNs typically have longer maturity dates—most mature 20-30 years from the original issue date—the adjustment of interest rates allows the price to remain fixed at par. The coupons on VRDNs usually reset daily or weekly based on the Securities Industry and Financial Markets Association (SIFMA) Municipal Market Swap Index—the municipal equivalent of the seven-day London Interbank Offered Rate (Libor)—as well as market supply and demand factors. As illustrated in the chart below, rates for the SIFMA Municipal Market Swap Index have ranged between zero and two percent since the beginning of 2016.
Bondholders have the option to put the security back to the issuing financial institution with seven day’s notice in return for full par value plus any accrued interest. This feature significantly enhances the liquidity of VRDNs and is what makes them eligible for purchase by money market funds.
Liquidity and Credit Support
Most VRDNs are supported by external credit enhancements in the form of an unconditional letter of credit (LOC) or a conditional standby purchase agreement (SPA) from a highly-rated financial institution. External credit enhancements reduce the risks associated with issuer default and ultimately improve liquidity. The LOC serves as an unconditional commitment by the financial institution to pay investors the principal and interest they are due, even in the event of downgrade, default or bankruptcy. A SPA, on the other hand, may be terminated if any of these events occur, depending on the terms of the agreement.
What are the advantages of investing in VRDNs?
Holding VRDNs can shorten the duration of a municipal bond portfolio or money market fund. In addition, the daily or weekly reset feature can be attractive in a rising rate environment because investors will always earn the prevailing market interest rate. Consequently, price risk is eliminated as the VRDN’s price always remains at par, making these securities appropriate for investors seeking capital preservation. Also, VRDNs typically have excellent liquidity due to short effective maturities and embedded put options. The LOCs and SPAs enhance the VRDN’s credit ratings and reduce default risk.
Who should purchase VRDNs?
For investors focused on capital preservation, VRDNs can be ideal, particularly in a rising rate environment. Further, because of their ultra-low duration and liquidity features, VRDNs are often appropriate for shorter-term cash management solutions. VRDNs trade in $100,000 increments, and sales transactions take a week (transaction date + 5 days or “T+5”) to settle.
Dan Skolochenko is a fixed income portfolio manager and trader in the CIBC Private Wealth Management San Francisco office, with more than 20 years of industry experience. Dan oversees taxable, national tax-exempt, and state-specific tax-exempt bond portfolios with objectives ranging from cash management/capital preservation to income-seeking intermediate duration accounts. Dan performs trading and analysis on all accounts under his supervision, and regularly provides commentary on investment strategy and market conditions to relationship managers.
Gary Pzegeo, CFA
May 17, 2016
Tim Musial, CFA
February 22, 2018
August 14, 2018
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