What it means
Governments and public bodies often borrow for twenty or thirty years to build schools, hospitals and infrastructure. A variable rated demand bond, or VRDB, has that long final maturity, but investors can ask for their money back at par after giving short notice, often seven days, and the interest rate is reset daily, weekly or monthly.
Short-term investors, such as money market funds, are happy to buy such bonds because their price barely changes and they can get their cash back quickly. Short-term interest rates are often lower than long-term rates, so the issuer can usually borrow more cheaply than with a fixed rate bond.
The structure depends on a remarketing agent and a liquidity provider. When a holder tenders the bond, the remarketing agent tries to resell it to a new investor at a rate low enough to attract a buyer.
If the agent cannot resell the bond, the liquidity provider, often a bank, buys it, and the bond becomes what the market calls a bank bond. Bank bonds usually carry a higher interest rate and a fast repayment schedule, which can strain the issuer's finances.
For the issuer, the all-in cost therefore includes the interest rate plus fees for the liquidity facility and the remarketing agent. The main risks are that short-term rates rise, that the liquidity provider's credit worsens, or that the facility expires and cannot be renewed.
Some issuers reduce the risk by pairing the bonds with an interest rate swap, which converts the floating rate into a fixed one. This brings its own risks, such as the swap not matching the bond rate exactly, and the arrangement should be reviewed by someone with the right expertise.
In practice
Real-world examples.
Example
A public hospital issues variable rated demand bonds to fund a new wing. A money market fund buys $10 million, attracted by the weekly reset and the seven-day put. The hospital pays a low floating rate plus fees.
Example
A transit authority finds that its bonds have been tendered and the remarketing agent cannot resell them. The bank liquidity provider buys them as bank bonds at a higher rate. The authority's finance team reviews its cash flow to meet the faster repayment schedule.
Example
A university pairs its variable rated demand bonds with an interest rate swap that pays a fixed rate. The result is a predictable cost for the next ten years. The finance team monitors the mismatch between the swap rate and the bond rate.
Formula
Calculation
Annual all-in cost = Principal x (Interest rate + Liquidity fee rate + Remarketing fee rate)
A city issues $50,000,000 of variable rated demand bonds. The average interest rate for the year is 3.0%, so interest = 50,000,000 x 0.03 = $1,500,000. The liquidity facility costs 0.60% a year, which is 50,000,000 x 0.006 = $300,000, and the remarketing agent charges 0.10%, which is 50,000,000 x 0.001 = $50,000. Total cost = 1,500,000 + 300,000 + 50,000 = $1,850,000, which is 1,850,000 / 50,000,000 = 3.70% of the amount borrowed.Case study
Seen in the real world.
This illustrative case follows a fictional county authority, Ridgemont County Water, which issued $80 million of variable rated demand bonds to build a treatment plant. The all-in cost was around 3.4% in the first year, well below the 5.0% it would have paid on a fixed rate bond.
In the third year, the bank providing the liquidity facility had its credit rating cut, and investors began to tender the bonds. The remarketing agent struggled to find buyers at the old rate, and the rate on the bonds rose sharply for several weeks.
The authority's finance director negotiated a replacement facility with a stronger bank and made some use of reserves to cover the higher cost. The fictional experience showed that the savings from variable rate funding come with risks that need monitoring and contingency plans.
Watch out
Common mistakes.
- Comparing only the interest rate with a fixed rate bond. The fees for the liquidity facility and remarketing add to the cost.
- Overlooking what happens if the bonds cannot be remarketed. Bank bonds carry higher rates and faster repayment, which can strain cash.
- Assuming the liquidity facility will always be renewed. If the facility expires or the bank's credit weakens, the issuer may face a sudden problem.
Questions
People also ask.
What does demand mean in the name?
It refers to the holder's right to demand repayment at par on short notice.
Why would an issuer choose variable rate over fixed rate?
Short-term rates are often lower than long-term rates, so the expected interest cost is lower, although the issuer takes on rate risk.
Who buys these bonds?
Mostly money market funds and other short-term investors, who like the stable price and ready access to cash.
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