Variable Rate Demand Note: Explaining VRDNs

What Is a Variable Rate Demand Note?

A variable-rate demand note (VRDN) is a debt instrument that represents borrowed funds that are payable on demand and accrue interest based on a prevailing money market rate, such as the prime rate. The interest rate applicable to the borrowed funds is specified from the outset of the debt and is typically equal to the specified money market rate plus an extra margin.

A VRDN is also referred to as a variable rate demand obligation (VRDO).

Understanding Variable Rate Demand Note (VRDN)

A variable-rate demand note (VRDN) is a long-term municipal bond which is offered to investors through money market funds. The notes allow a municipal government to borrow money for long periods of time while paying short-term interest rates to investors. As VRDNs are issued in a minimum of $100,000 denominations, smaller investors can only invest in VRDOs indirectly through money market funds.  

Because money market interest rates, such as the bank prime rate, are variable over time, the interest rate applicable to a variable rate demand note is variable as well. Every time the prevailing money market rate changes, a variable rate demand note's interest rate is adjusted accordingly. Typically, the interest rate on VRDN is adjusted daily, weekly, or monthly to reflect the current interest rate environment.

As the name implies, variable rate demand notes are payable on demand as they have an embedded put option. This means that the investor or lender of the funds can request a repayment of the entire debt amount at his or her discretion, and the funds must be repaid once the demand has been made. Depending on the demand feature affixed to these debt instruments, the investor may be required to provide a one-day or seven-day notification to tender the securities to a financial intermediary, such as a trustee or remarketing agent. Because of the demand feature, the maturity date of a VRDN is considered to be the next put date rather than its final maturity date.

Another feature of the VRDN that makes it an attractive investment option for money market investors is the credit enhancement that supports the demand note. A credit enhancement is a feature added to a security to improve its credit profile and mitigate default risk of the underlying assets. VRDN issuers employ credit enhancements through letters of credit (LOCs) from a highly rated financial institution, which serves as the liquidity provider of last resort, committed to supporting the timely payment of interest and repayment of principal on tendered securities. As long as the financial institution providing the letter of credit is solvent, the investor will receive payment. For this reason, the interest rate on VRDNs tends to reflect the short-term credit rating of the bank providing the letter of credit rather than the municipality issuing the VRDN. Another form of credit enhancement that may be used to reduce default risk is a standby bond purchase agreement which is typically provided by a reputable bank.

Variable-rate demand notes produce returns that have low correlations with stocks and bonds, thus, making them good investments for portfolio diversification. In addition, VRDNs issued by municipalities are generally exempt from federal taxes. Many issues are also exempt from state taxes in the state of issue.

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