What it means
The Municipal Securities Rulemaking Board's EMMA help page defines a VRDO as a municipal security whose interest rate resets periodically, which holders can liquidate through a put or tender feature at par. The MSRB's investor education brochure says VRDOs typically have a nominal long-term maturity of 20 to 30 years, and the rate resets daily, weekly, monthly, semi-annually or on a flexible basis.
Investors buy VRDOs at par in $100,000 increments, and the put lets the holder require repurchase at full face value plus accrued interest, generally with the rate reset and after notice to the tender agent. A remarketing agent sets the rate and resells tendered bonds to new investors, and the issuer pays that agent, although the agent has no obligation to buy the bonds itself.
Because the agent might not find buyers, VRDOs usually have a bank liquidity source, and the brochure names a letter of credit and a standby bond purchase agreement, while EMMA also mentions self liquidity provided by the issuer or an affiliate. A letter of credit typically gives an unconditional commitment by the bank to pay principal and interest, even on default, bankruptcy or downgrade of the issuer, so the credit rating then rests on the bank.
A standby purchase agreement only promises to buy tendered bonds and has termination events, and it does not guarantee principal and interest. The brochure lists three risks: interest rate risk, which is that short-term rates rise and the issuer pays more than fixed rate bonds would have cost, remarketing or put risk, which is that the agent cannot find buyers and the bank must pay par plus accrued interest, and rollover or renewal risk, which is that the issuer cannot replace an expiring bank facility at an acceptable price.
The brochure is dated 2016 and refers to LIBOR as a benchmark for taxable VRDOs, so benchmarks and market practice have changed since and current offering documents should be checked. It names the SIFMA Municipal Swap Index as the benchmark for tax-exempt VRDOs.
In practice
Real-world examples.
Example
A fictional city issues $50 million of 25 year bonds that reset weekly. Investors can tender the bonds at par on any reset date. The remarketing agent finds new buyers each time.
Example
A fictional investor holds a VRDO and tenders it on the reset date. The remarketing agent cannot find a buyer. The bank liquidity facility pays par plus accrued interest.
Example
A fictional issuer's bank facility is about to expire. The issuer cannot renew it at a price it likes. This is the rollover risk the MSRB describes.
Formula
Calculation
All-in annual cost = reset rate + liquidity fee + remarketing fee.
Worked example on $50 million with assumed figures: a 2.0% reset rate plus a 0.60% bank fee plus a 0.10% remarketing fee is 2.70%, or $50,000,000 x 2.70% = $1,350,000 a year. Fixed rate bonds at 4.5% would cost $50,000,000 x 4.5% = $2,250,000, so the variable structure saves $2,250,000 - $1,350,000 = $900,000.
If the reset rate rises to 5.0%, the all-in cost is 5.0% + 0.60% + 0.10% = 5.70%, or $2,850,000. That is $2,850,000 - $2,250,000 = $600,000 more than the fixed rate cost.Case study
Seen in the real world.
This case study is fictional and illustrative. A county plans to borrow $50 million for a hospital project. Its finance director compares fixed rate bonds with a VRDO. The fixed rate is 4.5%. The VRDO would reset weekly, and the county would pay a bank 0.60% for a letter of credit and 0.10% for remarketing.
At a 2.0% reset rate, the all-in cost is 2.70%. The director sees the savings of $900,000 a year. She also tests the risks. If rates rise to 5.0%, the cost becomes 5.70% and the VRDO is $600,000 a year more expensive than the fixed rate option. She also considers the liquidity facility.
If the bank will not renew when it expires, the county would have to find a replacement facility. The MSRB calls this rollover risk. The county chooses to issue part as VRDOs and part as fixed rate bonds. The lesson is that a variable rate can save money, but it moves the interest rate and renewal risk onto the issuer.
Watch out
Common mistakes.
- Treating a VRDO as a fixed rate bond, when its rate resets as often as daily or weekly.
- Assuming every liquidity facility guarantees payment, when the MSRB says a standby purchase agreement does not guarantee principal and interest.
- Counting only the reset rate, when the bank and remarketing fees add to the issuer's cost.
Questions
People also ask.
What is a VRDO?
It is a municipal bond whose interest rate resets periodically and that holders can put back at par.
Who sets the rate?
The remarketing agent usually sets it, and the same agent resells tendered bonds. The MSRB says the issuer pays the agent.
What happens if no one buys a tendered bond?
The tender agent or trustee draws on the letter of credit or standby purchase agreement for par plus accrued interest.
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