DEFINITION of 'Variable Rate Demand Bond'

A variable rate demand bond is a municipal bond with floating coupon payments that are adjusted at specific intervals. The bond is payable to the bondholder upon demand following an interest rate change. Generally, the current money market rate is what is used to set the interest rate, plus or minus a set percentage. As a result of this, the coupon payments can change over time.

BREAKING DOWN 'Variable Rate Demand Bond'

Municipal bonds are issued by state and local governments to raise capital to finance public projects, such as building hospitals, highways, schools, etc. In return for lending the municipalities money, investors are paid periodic interest in the form of coupons for the duration of the bond’s term. At maturity, the governmental issuer repays the face value of the bond to the bondholders.

While some muni bonds have fixed coupons, others are variable. Muni bonds with floating coupon rates are called variable rate demand bonds. These bonds have their interest rates generally reset periodically on a daily, weekly, or monthly basis. The bonds are issued for long-term financing with maturities ranging from 20 to 30 years. In addition, variable rate demand bonds require a form of liquidity in the event of a failed remarketing. The liquidity facility used to enhance the issuer's credit could be a letter of credit, standby bond purchase agreement, or self-liquidity, all of which assist in making these securities eligible for money market funds. For instance, a letter of credit provides an unconditional commitment by a bank to pay investors the principal and interest on the variable rate demand bonds, in the event of a default, bankruptcy, or downgrade of the issuer. As long as the financial institution providing the letter of credit is solvent, the investor will receive payment.

Variable rate demand bonds are issued with an embedded put feature that allows bondholders to tender the issues back to the issuing entity on the interest reset date. The put price is par plus accrued interest. The bondholders must provide notice to the tender agent by a specified number of days prior to the date that the debt securities will be tendered. A variable rate demand bond would normally be “put” if the holder wants immediate access to his or her funds or if market interest rates in the economy have increased to a level in which the current coupon rate on the bond is not attractive. If the bond is tendered prior to maturity due to an increase in rates, the remarketing agent will set a new, higher rate at which a remarketing agent can re-place the Bond. On the other hand, if market rates fall below the coupon rate, the agent will reset the rate at the lowest rate that will avoid a put being exercised on the bond.

Although a demand bond can be redeemed at any time, bondholders are often encouraged to keep the bonds in order to continue receiving coupon payments. The floating rate of the coupon payment contributes to higher uncertainty in coupon cash flows compared to generic bonds. Some of this risk is mitigated by the redemption option.

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