Variable-Rate Demand Bond: Definition and How It Works

Key takeaways

• A variable-rate demand bond (VRDB) is a long-term municipal bond with a floating coupon that is periodically reset (daily, weekly, or monthly).
• Holders typically have an embedded put (demand) option allowing them to tender the bond back at par plus accrued interest on reset dates.
• VRDBs generally include a liquidity facility (letter of credit, standby bond purchase agreement, or self‑liquidity) to cover payment if remarketing fails.
• These bonds combine long-term financing for issuers with short-term liquidity features for investors, but they carry credit, interest-rate, and liquidity risks.

What is a variable-rate demand bond?

A VRDB is a municipal security issued for long-term financing (often 20–30 years) whose coupon changes at preset intervals to reflect current short-term interest rates. Unlike fixed-rate municipal bonds, coupon payments on VRDBs float—usually tied to a money-market benchmark plus or minus a spread.

How the coupon rate and demand feature work

• Rate resets: The interest rate is reset on a regular schedule (commonly daily, weekly, or monthly) based on prevailing short-term market rates.
• Embedded put: On each reset date the bondholder can typically demand redemption (put the bond back to the issuer or a paying agent) at par plus accrued interest by giving required advance notice.
• Remarketing: If a bond is tendered, a remarketing agent attempts to sell it to new investors at a market-driven rate. If successful, the bond remains outstanding at the new rate; if not, the liquidity facility is drawn.

Liquidity facilities and credit enhancement

To make VRDBs practical for investors and eligible for money market funds, issuers obtain liquidity support:
* Letter of credit (LOC): A bank guarantees payment of principal and interest if the issuer or remarketing fails. Payment depends on the LOC provider’s solvency.
* Standby bond purchase agreement (BPA): A liquidity provider commits to buy tendered bonds if remarketing fails.
* Self-liquidity: The issuer maintains cash or a dedicated account to meet tendered redemptions.

These facilities lower immediate liquidity risk but introduce counterparty credit risk tied to the provider.

Typical investor actions and market dynamics

• Investors exercise the put when they want immediate access to cash or when the coupon becomes unattractive relative to market rates.
• If many holders tender simultaneously and the remarketing market is weak, the liquidity facility may be used to pay holders, potentially straining the provider or revealing credit weakness.
• Remarketing agents set rates to attract buyers; if market rates rise, the coupon is increased to reduce the likelihood of puts.

Benefits and risks

Benefits:
* Access to short-term liquidity while allowing issuers to secure long-term financing.
* Coupons adjust to current market conditions, which can protect investors from rising short-term rates.

Risks:
* Credit risk: Investors face both issuer credit risk and counterparty risk of the liquidity provider (e.g., bank backing an LOC).
* Liquidity and remarketing risk: Failed remarketing can force reliance on the liquidity facility.
* Interest-rate uncertainty: Floating coupons lead to variable income streams.
* Operational complexity and fees associated with remarketing and liquidity arrangements.

Considerations for investors

• Review the frequency of rate resets and tender notice requirements.
• Evaluate the creditworthiness of the issuer and any liquidity provider (LOC or BPA).
• Understand fees, the remarketing agent’s role, and the conditions under which the liquidity facility would be used.
• Confirm tax treatment (many VRDBs are municipals and may be tax-exempt) and suitability within your portfolio’s liquidity needs.

Summary

Variable-rate demand bonds blend long-term municipal financing with short-term liquidity via floating coupons and a put feature. They can offer flexibility and protection against rising rates but require careful assessment of issuer credit, liquidity providers, remarketing mechanisms, and the investor’s need for stable cash flow.