Variable-Rate Demand Bond
Candlefocus EditorMunicipal bonds may offer tax advantages that other debt securities do not. Such tax advantages, however, could vary drastically from one issuer to the next. Some local governments may be subject to federal and state taxes, while others may be exempt from taxation. As such, investors should always do their due diligence when considering municipal bonds.
VRDBs have no fixed interest payments but instead pay a rate that continually adjusts to prevailing market conditions as determined by a pricing index. The coupon rate of demand bonds will adjust usually on a weekly or monthly basis. Typically, the index used to set the payment rate is a money market index such as LIBOR. Since the coupon rate for VRDBs is established by the index, the income received from the VRDBs may be less reliable and may not provide the steady return investors may seek.
The demand feature of these bonds is a unique attribute not found in many other fixed-income securities. Demand-bonds allow investors the option to place a call and redeem their bond prior to maturity. The issuer must pay investors their principal plus accrued interest within 30 days of receiving the request.
The unique characteristics of VRDBs also come with some degree of risk. Interest rates can drastically change in short periods of time and investors may accordingly receive lower coupon payments than anticipated. For example, if interest rates rise above the predetermined target rate, investors may be receiving less income than expected. Similarly, if the index rate falls below the target rate, the issuer of the bond may not have to make the investors their full coupon payment unless the bond has a "soft call" provision which sets a lower payment stop.
In addition to the uncertainty of coupon payments, lenders are also exposed to the risk of the issuer's inability to make payments owed to investors. Investors may therefore consider credit ratings when selecting bonds and identify the strength and risk profiles of potential issuers.
For many investors, VRDBs continue to offer attractive yields and ultimately serve as an important source of revenue for states, local governments, and other government entities. Yet, given the volatility and degree of risk associated with VRDBs, investors must be aware of the potential pros and cons associated with these bonds before investing.