Variable-Rate Demand Bond

Definition

A Variable-Rate Demand Bond is a type of municipal bond that features both a variable interest rate and a put option that allows the holder to sell the bond back to the issuer at par value on specified dates. The interest rate is often reset periodically, typically weekly or monthly, and is linked to a certain benchmark such as the LIBOR. This bond is attractive to investors seeking higher returns, while the put option provides a level of security against rising interest rates.

Phonetic

The phonetic pronunciation of “Variable-Rate Demand Bond” is: “vair-ee-uh-buhl-reyt dih-mand bond.”

Key Takeaways

1. Variable-Rate Demand Bonds, also known as VRDBs or Variable-Rate Demand Obligations (VRDO), are municipal bonds where the interest rate is not fixed and can vary over time. This change depends on several factors including market conditions and the overall economic scenario.
2. These bonds carry a put or “demand” feature which allows the bondholder to sell the bond back to the issuer or to a third-party remarketing agent at par value plus accrued interest on any date with required notice. This provides liquidity to bondholders because it permits them to exit their positions whenever they want.
3. The interest rate of VRDBs typically resets regularly, such as daily or weekly. This frequent reset feature allows the bond’s interest rate to stay close to current market rates, making them less susceptible to price volatility in comparison to fixed-rate bonds.

Importance

Variable-Rate Demand Bonds (VRDBs) are significant financial instruments in the business and finance sector. They represent a type of municipal bond characterized by a long-term maturity and a short-term put option, enabling investors to sell them back to the municipality at par value, with accrued interest, during agreed periods. Their importance lies in their flexible interest rates, which are adjusted periodically, typically daily or weekly. This attribute can provide a hedge against inflation and interest rate risk for investors. Moreover, VRDBs can also offer municipalities lower borrowing costs, increased liquidity due to the demand feature, and a diversified investor base, thus playing a crucial role in public project financing.

Explanation

A Variable-Rate Demand Bond (VRDB) is a type of bond that seeks to offer a versatile and flexible tool for both issuers and investors in the financial market. The primary purpose of a VRDB is to provide short-term liquidity at a minimal cost for issuers, usually municipal entities or corporations. The bond’s interest rate is regularly reset, typically daily or weekly, allowing issuers to benefit from the prevailing low short-term interest rates. For the issuers, this flexibility can assist in more refined management of their financial risk and cash flow by aligning their liabilities with their current capabilities and assumptions. From an investor’s perspective, VRDBs are sought after for their liquidity and price stability. The embedded ‘put’ option, which allows investors to sell the bonds back to the issuer or a third-party financial institution, offers a high level of protection and liquidity. This feature becomes particularly significant during periods of market uncertainty or increased interest rate volatility. The interest rate adjustments on the bonds provide the opportunity for investors to reap the benefits of a rising interest-rate environment, making these bonds an appealing option for those looking to protect against interest rate risk.

Examples

1. Municipal Bonds – Local governments often issue variable-rate demand bonds to finance infrastructure projects like schools, roads, or other public works. The interest rates on these bonds vary, depending on current market rates, and investors can ‘put’ the bond back to the issuer at any time if rates rise above a certain level, which provide liquidity to the bondholders. 2. Student Loans – Most student loans in the United States are variable-rate demand bonds. They have interest rates that change over the life of the loan based on changes in the market interest rates. Borrowers may demand full repayment of the loan at any given time, provided they pay any associated fees or penalties. Variable-Rate Demand Bond3. Commercial Paper – a prime example of a variable-rate demand note is commercial paper. These short-term, unsecured promissory notes issued by corporations have a variable interest rate. The company issuing the note can choose to repay the investor at any time, and the investor can choose to demand repayment at any time. For instance, a firm may issue commercial paper to finance short-term operational needs like payroll or inventory purchases. Remember, variable rates can go both ways for the investor and the issuer, either benefiting or hurting the return of the investment or the cost of the loan.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Bond Market
• Interest Rate
• Liquidity Provider
• Principal Amount
• Maturity Date

Sources for More Information

• Investopedia
• Black Rock
• Finance Strategists
• Corporate Finance Institute