Variable Rate Demand Note

Bond investment often stabilises the portfolio, and among the various types of bonds available in the market, one of the most peculiar instruments is the Variable-Rate Demand Note (VRDN). VRDNs are short-term debt instruments with a variable rate of interest that provide flexibility and liquidity and, hence, appeal to a specific class of investors. 

In this blog, we look at what VRDNs are, how VRDNs work, and how they are different from other bonds. Through these blog posts, you can clearly understand your potential suitability as an investor for these instruments. 

What is Variable Rate Demand Note? 

A VRDN is a debt security issued at a floating interest rate, generally linked to benchmarks such as the London Interbank Offered Rate, commonly referred to as LIBOR, or other benchmark rates. In contrast to a fixed-rate bond, the interest on a VRDN adjusts periodically, removing the large risk it faces in the ups and downs of long-term rates. 

A defining feature of a VRDN is that with seven days’ notice, it can usually be “put” or redeemed at the stated par value. Thus, VRDNs make a compelling investment vehicle for an investor who desires liquidity and to be compensated for interest rate risk. Often, an issuing entity is a municipality, a non-profit, or a government agency, making the VRDNs one of the safer kinds of investments. 

Understanding Variable Rate Demand Note 

To fully comprehend how a VRDN operates, we need to understand two of its most important terms: variable interest rate and demand feature. 

Variable Interest Rate: The interest rate for a VRDN changes periodically and is set based on an index of short-term interest rates, like LIBOR or a municipal bond index. Since yield and supply are incorporated, a VRDN is in a better position to offer rates that are more reflective of current market conditions than fixed-rate bonds. 

As interest rates increase, the rates on VRDNs increase; this protects the investor from the interest rate risk usually associated with fixed-rate bonds. 

Demand feature: A VRDN’s demand feature allows investors to call their notes back to the issuer at any time, usually with seven days’ notice. This adds a layer of comfort since, unlike a traditional long-term bond, the investor can liquidate the investment and return the principal in short order. 

Types of Variable Rate Demand Note 

There are several types of VRDNs, and understanding each type can help investors determine which one best suits their needs. 

1. Tax-Exempt VRDNs

Tax-exempt VRDNs are mostly issued by municipalities or non-profit organizations and offer interest that is exempt from federal income tax. That makes them attractive to high-net-worth individuals or investors in high tax brackets. Municipal VRDNs, for example, are particularly favoured for this tax benefit in the US. 

2. Taxable VRDNs

These VRDNs have no distinctions with their tax-exempt relatives other than one major one: they do not have a tax-exempt benefit. A higher interest rate may be promised to compensate for the lost benefit. More general entities issue them, and they may be held in various types of portfolios. 

3. Puttable VRDNs

Although this kind of VRDN also provides the issuer with the added flexibility of taking it back in, an investor can redeem this security anytime. This is particularly useful for investors who are looking for short-term liquidity. 

Advantages and Disadvantages 

Advantages of VRDNs 

• Liquidity: The demand feature enables VRDNs’ high liquidity. Most importantly, an investor can redeem the investment on short notice, making VRDNs appropriate for investors who need short-term cash to manage their funds. 

• Variable Interest Rate: The bond’s interest rate varies with the market’s prevailing condition, which protects the increasing rate. 

• Tax Advantages: VRDNs are generally tax-exempt, so interest is free from federal taxation, making them more financially viable. 

• Low Volatility: Due to the small investment span, VRDNs are less volatile than long-term bond investments. 

Disadvantages of VRDNs 

• Lower Returns: VRDNs’ very short-term character and high liquidity usually result in lower returns compared to longer-term, higher-risk investments. 

• Rate Decline Risk: With declining interest rates, the returns to VRDNs also go down, and they could become less attractive in a low-rate environment. 

• Credit Risk: As in the case of any bond, there is always a certain risk that the corporate entity could default, although this can be quite low for municipalities or government agencies backing VRDNs. 

Examples of Variable Rate Demand Note  

1: VRDN issued by Municipality 

In the US, a local government-issued tax-exempt municipal VRDN is used to finance infrastructure projects. The rate is tied to a short-term municipal bond index. The investor can redeem such a note with seven days’ notice. There, the investor enjoys interest income without accumulated tax while still having access to his principal in case of need. 

2: Corporate VRDN 

A big company in Singapore aims to expand its business and decides to issue a taxable VRDN. It would be linked to LIBOR and reset every week. The company gives the investor a put option, which allows investors to redeem this note at par value. Since the investor can get higher yields compared to any normal savings account, investors get a potential good return with an option to get out of the investment. 

Frequently Asked Questions