What is a Variable Rate Demand Note?
A Variable Rate Demand Note (VRDN) represents a unique way for investors to benefit from debt instruments that offer flexibility. VRDNs provide investors the power to demand repayment on borrowed funds while earning interest based on prevailing money market rates. These rates often follow benchmarks like the prime rate, plus a predetermined margin.
VRDNs may also be known as Variable Rate Demand Obligations (VRDOs).
Embrace the Dynamics of VRDNs
A Variable Rate Demand Note (VRDN) is essentially a long-term municipal bond introduced to investors through money market funds. This financial instrument allows municipal governments to fund projects over extensive periods while paying short-term interest rates to investors. Issued in minimum denominations of $100,000, this imposes a barrier for smaller investors, who can indirectly invest through money market funds.
Since money market interest rates are subject to variability, a VRDN’s interest rate changes with them. Whenever the benchmark money market rate such as the bank prime rate fluctuates, so does the interest of the VRDN. Generally, the adjustment to the interest rates can be daily, weekly, or monthly, maintaining alignment with the current interest environment.
One key attribute of the VRDN includes an embedded put option. This feature first signifies that it’s payable on demand. An investor can request complete repayment of their funds anytime, similar to exercise a put option in an options contract. Depending on how this feature is structured, investors might need to provide a notice ranging from one-day to seven-day to tender the VRDN to a financial intermediary like a trustee or a remarketing agent. The maturity date is, therefore, the upcoming put date rather than the note’s final maturity date.
Additionally, VRDNs attract investment by employing credit enhancement strategies. These are added features to boost the credit profile and mitigate default risk associated with the notes. Issuers usually obtain letters of credit (LOCs) from highly rated financial institutions to ensure they can meet interest and principal repayments, safeguarding investor’s payouts as long as the backing institution remains solvent. Sometimes, a standby bond purchase agreement enhances credit further.
VRDNs allow investors to enjoy benefits like portfolio diversification, thanks to their typically low correlation with stocks and bonds. Furthermore, municipal VRDNs often come with the added inducement of being exempt from federal and sometimes state taxes, enhancing their attractiveness.
Investing in VRDNs could be a diversified means to incorporate variances of short-term, low-risk instruments into one’s investment strategy.
Related Terms: Municipal Bonds, Money Market Funds, Bond Purchase Agreement, Default Risk, Prime Rate, Diversification.
