Variable Rate Demand Notes – What They are and How They Work

Variable Rate Demand NotesVariable rate demand notes are a mechanism that allows a municipality to borrow money for long-periods of time while paying short-term rates. For investors, variable rate demand notes provide a very liquid, generally tax-exempt investment.

Prior to 2008, many municipalities and local agencies were very concerned about lowering the amount interest they were paying on the municipal bonds they issued.  The easiest way to lower their borrowing rate was to borrow for shorter periods of time, and take advantage of the large difference between lower short-term interest rates and higher long term rates. However, this would put municipalities or agency in a position where they might not be able to easily repay or refinance their short-term debt. Variable Rate Demand Notes provide municipal issuers a way to pay short-term rates while, limiting the potential consequences of market liquidity disappearing.

How do Variable Rate Demand Notes Work?

The main type of VRDN is backed by an irrevocable, direct-pay letter of credit.

Here is how it generally works: Variable Rate Demand Notes are sold to investors which historically have included high net worth individuals, corporations, and money-market funds. The key feature of the VRDN is the ability of the investor to sell the bond at its full face value with a short-period of notice. Typically, the investor must notify the “remarketing agent” at least 7 days prior to their intent to sell the note.  The “remarketing agent” plays a key role with Variable Rate Demand Notes. Their job is to set the interest rate which the VRDN pays investors. As the name implies, the rate of a variable demand note changes over time. Typically, the “remarketing agent” is able to re-set the rate every week. However, the reset may occur daily or monthly depending on VRDNs structure. The challenge of the “remarketing agent” is to keep borrowing costs down for the municipality while keeping interest rates attractive enough that existing investors continue to hold their notes or new investors will find the rate attractive.

What happens if no one wants to buy the Variable Rate Demand Note?

In this case, the “remarketing agent” draws upon the letter of credit that the municipality has set-up. As long as the financial institution (bank) providing the letter of credit is solvent, the investor will receive payment. As a result, the interest rate on Variable Rate Demand Notes tend to reflect the short-term credit rating of the bank providing the letter of credit rather than the underlying municipality issuing the VRDN.

The recent news around Variable Demand Notes is that the banks providing this financial backstop for investors in the VRDN may not be in great financial shape. In particular, Moody’s has the short-term ratings of Citigroup ( C) and Bank Of America (BAC) under review.

Are Auction Rate Securities and VRDNs the same?

In the older version of the article, the author confused these two very different types of fixed income investments. While they are designed to provide the municipality or agency the same benefit, they operate very differently. One primary difference is that Auction Rate Securities do not provide the liquidity benefit to investors as a Variable Rate Demand Notes.

Note of Thanks: I would like to thank the Municipal Bond Forum group on LinkedIn for providing feedback. Any errors in this article are my misunderstanding the feedback they provided or my effort to simplify this complicated subject matter. Special Thanks to Scott Brinkman, Donald Clements, Susan Munson of Fixed Income Academy, David Tiffin, Mark Chaiken, Chuck Devers, Steve Eikenberry, Erik Chavez, Ira Goldberg, and as always Cate Long of Muniland.

For the definition and explanation of more bond related words visit the Learn Bonds glossary where we give the meaning of many additional terms.

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