Variable-Rate Demand Notes (VRDNs)

Variable-Rate Demand Notes (VRDNs) are a clever type of municipal bond or other long-term debt instrument that behaves like a short-term investment. Think of it as a financial chameleon. On paper, a VRDN might have a maturity date 20 or 30 years in the future, but it has two special features that make it act like cash in the bank. First, it pays a floating interest rate that resets very frequently, often every day or every week. Second, and most importantly, it includes a “demand feature,” which is essentially a put option. This powerful feature gives you, the investor, the right to sell the note back to the issuer (or their designated agent) at its full par value plus any interest you've earned, with just a few days' notice. This combination of a floating rate and a demand feature makes VRDNs highly liquid and keeps their price extremely stable, making them a popular choice for parking cash safely.

The magic of a VRDN lies in its two-part structure, which is designed to protect your principal from the pesky effects of market fluctuations.

Unlike a traditional fixed-rate bond that pays the same coupon for its entire life, a VRDN has its interest rate adjusted at regular, short intervals. This task is handled by a financial institution called a remarketing agent. Their job is to set the rate—known as the “clearing rate”—at a level that makes the note's market value exactly equal to its par value ($1.00 on the dollar). In a rising interest rate environment, the agent will raise the VRDN's rate to keep it attractive. This mechanism is the primary defense against interest rate risk, the danger that your bond's value will fall as prevailing rates rise.

This is your escape hatch and the source of a VRDN's fantastic liquidity. If you need your money back for any reason—perhaps you disagree with the new interest rate or you've found a better investment—you can “put” the note back. You simply notify the remarketing agent, and within a short period (typically 7 days), you receive your full principal investment plus accrued interest. To guarantee this process works flawlessly, most VRDNs are backed by a letter of credit (LOC) or a similar guarantee from a highly-rated bank. This is a form of credit enhancement. It means that if the remarketing agent can't find a new buyer for your note, the bank steps in and buys it from you. This adds a crucial layer of safety.

For investors following the principles of value investing, VRDNs check several important boxes, particularly concerning the preservation of capital and the strategic use of cash.

Warren Buffett's first rule is “Never lose money,” and his second is “Never forget Rule No. 1.” VRDNs are built for this philosophy. Their stable value and on-demand liquidity make them a superb cash-equivalent instrument, much like a money market fund. Value investors often need to hold significant amounts of cash while they wait patiently for the market to serve up an undervalued gem. VRDNs provide a secure and productive place to park that “dry powder,” earning a modest return while ensuring the capital is ready to be deployed at a moment's notice.

Because most VRDNs are municipal bonds, the interest they pay is often exempt from federal income tax. Furthermore, if you invest in a VRDN issued by a municipality within your own state of residence, the income may also be exempt from state and local taxes. This “triple tax-exempt” status can significantly boost the tax-equivalent yield, making a 2% tax-free return feel like a 3% or 4% taxable return, depending on your tax bracket.

While VRDNs are considered very safe, no investment is entirely without risk. It's important to understand the potential weak points.

• Credit Risk: This risk comes in two forms. First is the issuer risk—the chance that the underlying municipality could face financial distress and be unable to make its payments. Second, and more critical for a VRDN, is the counterparty risk associated with the bank providing the letter of credit. The entire safety net of the demand feature relies on this bank's financial strength. Therefore, you are exposed to the creditworthiness of both the municipality and the bank.
• Failed Remarketing: This is the nightmare scenario, though extremely rare. A failed remarketing occurs if the remarketing agent cannot reset the rate at a level that attracts buyers, and the bank backing the LOC fails simultaneously and cannot honor its commitment to buy the notes. This perfect storm, seen in isolated cases during the 2008 financial crisis, could cause the VRDN to become illiquid and lose value. For this reason, investors should always scrutinize the credit ratings of both the bond issuer and the bank providing the liquidity guarantee.