Variable-Rate Demand Obligation (VRDO)

A Variable-Rate Demand Obligation (VRDO) is a clever type of long-term municipal bond that behaves like a short-term investment. Think of it as a financial chameleon. While it might have a formal maturity date 20 or 30 years in the future, it comes with two special features that give investors flexibility and safety. First, its interest rate isn't fixed; it adjusts frequently, often every week or even daily. This keeps the bond's price incredibly stable. Second, and most importantly, it includes a demand feature, or put option, which gives the investor the right to sell the bond back at its full face value (par value) with very short notice, typically seven days. This combination of a floating rate and a sell-back option makes VRDOs highly liquid and low-risk instruments, making them a favorite holding for money market funds and conservative investors looking for a safe place to park cash while earning tax-free income.

The magic of a VRDO lies in its structure, which is designed to provide stability in a fluctuating market. It achieves this through its two core components: the variable interest rate and the demand feature.

• The Floating Interest Rate: Instead of being locked into a single interest rate for decades, a VRDO's rate is reset periodically by a financial institution known as a remarketing agent. This agent's job is to set the rate at a level that is just high enough to make the bond worth exactly its par value in the current market. By continuously adjusting the yield to match market conditions, the bond's price is protected from the volatility that plagues fixed-rate bonds when interest rates change. This nearly eliminates interest rate risk for the holder.
• The Demand Feature (The “Put”): This is your escape hatch. The put option is a legally binding promise that allows you, the investor, to “put” the bond back to the issuer (or their agent) and receive your principal in full, usually within seven days. This feature provides phenomenal liquidity. If you need your cash or see a better investment opportunity, you aren't stuck holding the bond for years; you can simply cash out.

What if the municipality is short on cash when a lot of investors decide to sell at once? This is where the real security of a VRDO comes in. To ensure investors can always get their money back, most VRDOs are backed by a credit enhancement, typically in one of two forms:

• A Letter of Credit (LOC): This is a guarantee from a highly-rated bank. If the remarketing agent can't find a new buyer for the bonds you want to sell, the bank that issued the LOC steps in and pays you.
• A Standby Bond Purchase Agreement (SBPA): This serves a similar function to an LOC, obligating a liquidity provider (usually a bank) to purchase any bonds that cannot be remarketed.

In either case, the ultimate credit risk you are taking is not on the municipality that issued the bond, but on the major bank providing the guarantee.

VRDOs offer a unique blend of safety, liquidity, and tax advantages, but they come with trade-offs.

1. Price Stability: Thanks to the rate resets and the put feature, the value of a VRDO barely budges. This makes it an excellent tool for preserving capital and minimizing principal risk.
2. Exceptional Liquidity: The ability to sell back at par on short notice makes VRDOs almost as liquid as cash in a bank account.
3. Tax Advantages: As municipal securities, the interest earned from VRDOs is typically exempt from U.S. federal income tax and, if issued in your home state, may also be exempt from state and local taxes.

1. Lower Yield: You don't get all that safety for free. The yield on a VRDO is typically lower than what you would earn on a long-term, fixed-rate bond. It's often comparable to the yield on other highly liquid, short-term investments like Treasury bills, but with the added tax benefit.
2. Bank Credit Risk: The primary risk is not that the city of Anytown will go bankrupt, but that the big bank providing the letter of credit will. If the guarantor bank fails, your put option could become worthless, and the bond's value could plummet. Therefore, analyzing the creditworthiness of the backing bank is paramount.

For a value investor, VRDOs are not typically a tool for achieving spectacular capital gains. You won't find a VRDO trading for 50 cents on the dollar that you can ride back to par. Their very structure is designed to prevent price fluctuation. However, they serve an incredibly important purpose in a value-oriented strategy: they are an outstanding place to park cash. When you've sold an overvalued stock or are waiting for the market to present a “fat pitch” opportunity, a VRDO offers a superior alternative to a standard savings account. It provides better after-tax returns than most cash equivalents, with near-perfect liquidity and minimal risk to your principal. The “value” analysis for a VRDO investor shifts from the bond issuer to the credit guarantor. Before investing, the crucial question to ask is not “How sound is this municipality?” but rather, “How sound is the bank backing this bond?” A VRDO backed by a fortress-like financial institution is one of the safest investments you can find.