Variable Rate Demand Note
A variable-rate demand note (VRDN) is a debt instrument that represents borrowed funds that are payable on demand and accrue interest based on a prevailing money market rate, such as the prime rate. The interest rate applicable to the borrowed funds is specified from the outset of the debt and is typically equal to the specified money market rate plus an extra margin.A VRDN is also referred to as a variable rate demand obligation (VRDO).
Variable Rate Demand Notes (VRDN)
Definition
Variable Rate Demand Notes (VRDN) are a type of debt instrument that represents borrowed funds, which can be repaid at any time and accrue interest based on current money market rates (such as benchmark rates). The interest rate on the borrowed funds is determined at the inception of the debt and typically equals the specified money market rate plus an additional spread. VRDNs are also known as Variable Rate Demand Obligations (VRDO).
Origin
VRDNs originated in the 1980s when the financial markets needed a flexible short-term financing tool to cope with interest rate fluctuations and liquidity demands. As the money market evolved, VRDNs became an important tool in the municipal bond market.
Categories and Characteristics
VRDNs are mainly divided into two categories: municipal VRDNs and corporate VRDNs. Municipal VRDNs are typically issued by local governments or municipal agencies for public projects like infrastructure development, while corporate VRDNs are issued by companies for short-term financing needs. Key characteristics include:
- Floating Interest Rate: The interest rate is periodically adjusted based on market rates, usually weekly or monthly.
- High Liquidity: Investors can demand repayment of the principal at any time, often supported by liquidity arrangements such as standby letters of credit from banks.
- Lower Risk: Due to liquidity support and short interest rate adjustment periods, VRDNs have relatively lower credit and interest rate risks.
Specific Cases
Case 1: A city government issues a batch of municipal VRDNs to fund the construction of a new public transportation system. Investors purchase these notes and receive interest adjusted weekly based on current money market rates. If investors need funds, they can demand repayment of the principal at any time.
Case 2: A large corporation issues corporate VRDNs to meet short-term operational funding needs. The company adjusts the interest on the notes monthly based on market rates and ensures investor liquidity needs through standby letters of credit from banks.
Common Questions
1. What are the main risks of investing in VRDNs?
The main risks include interest rate risk and credit risk, but these are relatively low due to periodic interest rate adjustments and liquidity support.
2. How do VRDNs differ from fixed-rate bonds?
VRDNs have floating interest rates that adjust periodically based on market rates, whereas fixed-rate bonds have interest rates set at issuance that do not change with the market.
