Variable Rate Demand Note (VRDN)

Definition

A Variable Rate Demand Note (VRDN) is a type of debt instrument that represents borrowed funds, typically issued by municipalities, with a floating interest rate. This interest rate is reset periodically and is usually based on a benchmark such as a money market rate or an index. The unique feature of VRDN is that it provides the investor with the right to demand payment of the principal plus accrued interest with a specific notice period.

Phonetic

Variable Rate Demand Note (VRDN) is pronounced as:- VEHR-uh-buhl Rate duh-MAND noht (VRDN)- Vee-Ahr-Dee-En

Key Takeaways

VRDN is a type of debt instrument that allows investors to take advantage of changes in interest rates. Its interest rates can be adjusted daily, weekly, or monthly depending on the specific terms of the note. These adjustments are often pegged to an index, such as the London Inter-bank Offered Rate (LIBOR). These notes come with a put option which means that the investor has the option to sell back the note to the issuer or a third-party liquidity provider at par value. This feature makes VRDNs very liquid instruments as compared to other types of debt. While VRDNs offer flexibility and liquidity, they also come with potential risks. The primary risk associated with this type of debt is that the value may fall if interest rates decline and because they are not a common investment, there may not be as much demand for these notes in the market. Additionally, if the issuer or liquidity provider is unable to fulfill its obligation to repurchase the note at par, the investor could suffer a loss.

Importance

A Variable Rate Demand Note (VRDN) is important in business and finance as it provides investors with a flexible and liquid investment option. As it’s a debt instrument that represents borrowed funds to be repaid with interest varying on market conditions, it offers potential attractive yields when market interest rates are high. The demand feature gives investors the advantage of having immediate liquidity since it can be sold back to the issuer or to a third-party remarketing agent at any time. Importantly, the floating interest rate provides a cushion against interest rate risk, typically making it a safer investment during periods of increasing interest rates. Its features draw in a diverse range of investors like money market funds, mutual funds and individual investors.

Explanation

A Variable Rate Demand Note (VRDN) is a type of investment instrument commonly utilized by corporations or municipalities when they are seeking to generate funds for various organizational purposes. The purpose of a VRDN is to give issuers flexibility in managing their interest expenses, as the rate of interest adjusts periodically according to current market rates. This helps organizations to not lock themselves into a fixed interest cost during periods where interest rates might be expected to fall. Also, the “demand” feature of VRDNs provides a degree of liquidity to the investment, as the holder can essentially sell the note back to the issuer or a third party, typically on seven days’ notice. From the investor’s perspective, VRDNs can also play a significant role in their portfolios. They are considered a relatively safe, short-term investment, and the variable interest rate aligns with the fluctuations of the market, potentially providing higher returns when interest rates rise. Furthermore, because VRDNs are often federally tax-exempt and can be sold back relatively quickly, they carry lower risk compared to some other types of investments. Thus, they can be an important tool for managing both liquidity and interest rate risk in an investment portfolio.

Examples

1. Municipal bonds: Cities or local governments often issue variable rate demand notes to raise funds for various projects, such as constructing schools or improving infrastructure. Since these notes have variable interest rates, they can be more appealing to investors when interest rates are expected to rise. For instance, New York City issued VRDNs to finance its public housing projects. 2. Corporate short-term borrowing: Companies frequently use VRDNs as a method of short-term financing. For example, a large multinational corporation might issue VRDNs to cover operational costs or finance expansion before the revenue from the new investment comes in. Procter & Gamble Co., a multinational consumer goods corporation, has previously used VRDNs as part of its comprehensive financial strategy. 3. Money Market Funds: VRDNs often form a significant part of a money market fund’s investment portfolio. Money market funds aim to provide investors with a safe place to invest easily accessible, yet still relatively high-yielding, cash-equivalent assets. These funds use VRDNs because they offer slightly higher interest rates compared to other short-term investments and their rate variability can offer potential returns in rising markets. Vanguard Prime Money Market Fund, for example, holds a large percentage of its portfolio in VRDNs.

Frequently Asked Questions(FAQ)

What is a Variable Rate Demand Note (VRDN)?

A Variable Rate Demand Note (VRDN) is a type of debt instrument that contains a long-term maturity but allows the holder the option to redeem it at a predetermined price on certain days. The interest rate of a VRDN is adjusted frequently, typically daily or weekly, providing investors with a relatively liquid and low-risk investment option.

How is the interest rate on a VRDN determined?

The interest rates on VRDNs are primarily determined by market conditions such as supply and demand dynamics. They are revised at regular intervals, often pegged to a benchmark such as the SIFMA index or the LIBOR, ensuring that they stay competitive and attractive to investors.

What are the risks associated with VRDNs?

While VRDNs are generally considered as a low-risk investment, they may carry certain risks like interest rate risk, liquidity risk and credit risk. Interest rate risk arises when there’s a fluctuation in the market interest rate, affecting the yield of the VRDN. Liquidity risk comes from the possibility that the note might not be easily convertible to cash without loss of value. Credit risk involves the possibility of the issuer defaulting on payments.

Who typically invests in VRDNs, and why?

VRDNs are often attractive to money market investors, institutional investors and individual investors seeking a liquid, low-risk investment with a stable yield. They also offer potential tax advantages, making them attractive to investors seeking tax-exempt income.

Are VRDNs tax exempt?

Yes, generally VRDNs are tax-exempt instruments, meaning the interest received from these notes will not be subject to federal taxes. However, tax regulations can vary by state and every investor should consult with a tax advisor to understand the specific tax implications.

How can I invest in a Variable Rate Demand Note (VRDN)?

VRDNs are often bought and sold through financial advisors, brokers, or other financial professionals. They can also be included as a part of a money market fund or other investment funds. It is advisable to consult with a registered financial advisor before purchasing a VRDN.

Related Finance Terms

Short-Term Debt Instrument
Resale Provision
Liquidity Provider
Floating Interest Rate
Money Market Fund

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