What is a variable rate demand note?
A debt instrument known as a variable-rate demand note (VRDN) is borrowed money due on demand and accrues interest at the prime rate or another current money market rate. The interest rate that applies to the borrowed capital is predetermined at the commencement of the loan and is often equal to the established money market rate plus an additional margin.
A variable rate demand obligation (VRDO) is another name for a VRDN.
Understanding Variable Rate Demand Note (VRDN)
A long-term municipal bond known as a variable-rate demand note (VRDN) is made available to investors via money market funds. A local government may borrow money for extended periods and pay investors short-term interest rates using the notes. Smaller investors are limited to investing in VRDOs indirectly via money market funds since VRDNs are only issued in quantities of $100,000 or more.
The interest rate that applies to a variable-rate demand note is changeable because money market interest rates, like the bank prime rate, fluctuate over time. The interest rate on a variable-rate demand note is modified in line with changes in the going rate in the money market. The interest rate on VRDN is often changed daily, weekly, or monthly to reflect the state of interest rates.
Variable rate demand notes include an embedded put option, making them pay on demand, as the name suggests. This implies that the fund’s investor or lender may, at their discretion, demand repayment of the whole loan amount and that, upon making such a demand, the money will be returned. The investor may be obliged to provide a one-day or seven-day notice to tender the securities to a financial intermediary, such as a trustee or remarketing agent, depending on the demand feature attached to these debt instruments. The maturity date of a VRDN is regarded as its next put date rather than its ultimate maturity date because of the demand characteristic.
The credit enhancement supporting the demand note is another element of the VRDN that attracts money market investors as an investment opportunity. A feature applied to a security to raise its credit profile and lower the default risk of the underlying assets is known as a credit enhancement. VRDN issuers use credit enhancements using letters of credit (LOCs) obtained from a highly esteemed financial institution. These LOCs function as the last-resort liquidity source, pledging to facilitate the prompt payment of interest and principal repayment on tendered securities. The investment will be paid if the financial organization is stable and issues the letter of credit. Because of this, rather than the municipality issuing the VRDN, the interest rate on VRDNs often reflects the short-term credit rating of the bank providing the letter of credit. A standby bond purchase agreement, usually offered by a respectable bank, is another kind of credit enhancement that may be used to lower default risk.
Variable-rate demand notes are suitable for portfolio diversification since they provide returns unrelated to equities and bonds. Furthermore, municipalities’ VRDNs are often free from federal taxes. Several problems are also free from state taxes in the state of issue.
Conclusion
- Learn all there is to know about variable rate demand notes (VRDNs) by reading this in-depth overview of their unique features.
- Discover the nuances of VRDNs and learn about their nature and operating dynamics to make wise decisions.
