A variable-rate demand bond (VRDB) stands out in the investment world as a unique type of municipal bond featuring floating coupon payments adjusted at predetermined intervals. These bonds come with a flexible interest rate that acclimates to the current money market rate plus or minus a set percentage, influencing coupon payments over time.
Key Highlights
- VRDBs are a form of municipal bond that feature floating coupon payments adjusted at specific intervals.
- Municipal bonds are primarily issued by local and state governments to fund significant public projects.
- The floating rates introduce an element of uncertainty, but some risks can be mitigated through various mechanisms like redemption options.
Unveiling the Dynamics of Variable-Rate Demand Bonds
Bondholders retain the discretion to redeem a demand bond at their convenience, though retaining these bonds may be favorable for continued coupon payments. Unlike standard municipal bonds, the variable nature of VRDB coupon payments adds an extra layer of unpredictability to cash flows. However, redemption options can help offset some of these risks.
Municipal bonds are instrumental for state and local governments to fund public initiatives, such as infrastructure developments like hospitals, highways, and schools. Investors earn periodic interest via coupons throughout the bond’s term, and the bond issuer repays the face value upon maturity.
Some municipal bonds offer fixed coupons, whereas others, like VRDBs, have variable coupons. Adjustable at daily, weekly, or monthly intervals, the interest rates on these bonds can vary substantially. VRDBs are typically issued for long-term horizons, ranging from 20 to 30 years.
Furthermore, VRDBs necessitate liquidity mechanisms to accommodate potential market failures. Such measures could include letters of credit, standby bond purchase agreements (BPA), or self-liquidity solutions to ensure these securities’ acceptance by money market funds.
For example, a letter of credit entails an unconditional commitment by a solvent bank to repay investors the principal and interest should the issuer go into default or bankruptcy. This becomes a safeguard for the investors as long as the bank remains solvent.
The Strategic Advantages of Early Redemption
These bonds often incorporate an embedded put feature that allows holders to tender the bonds back to the issuer on the interest reset date. Redemption at this juncture occurs at a par value plus accrued interest. Notice must be provided to the tender agent ahead of the tender date.
Bondholders may choose to exercise the put if they need immediate liquidity or if prevailing market interest rates surpass the current coupon rate, making the bond less attractive. In such cases, the remarketing agent will adjust the interest rate. If market rates increase, a new, higher rate will be set. Conversely, if rates decrease, the agent will seek the lowest possible rate to avert a put exercise.
Incorporating such bonds into an investment portfolio requires an understanding of their dynamic nature and strategic liquidity options. As an investment, VRDBs offer bouncing opportunities, especially for investors seeking versatile income streams adaptable to fluctuating market conditions.
Related Terms: municipal bond, coupon, money market rate, redemption, issuer, face value, coupon rate, interest rate, credit enhancement, letter of credit, bond purchase agreement, par value, embedded option, exercise, remarketing agent
References
- U.S. Securities and Exchange Commission. “Municipal Bonds”.
