What Is a Variable-Rate Demand Bond?

A variable-rate demand bond is a type of municipal bond (muni) with floating coupon payments that are adjusted at specific intervals. The bond is payable to the bondholder upon demand following an interest rate change. Generally, the current money market rate is used to set the interest rate, plus or minus a set percentage, which may result in a change in coupon payments over time.

Understanding Variable-Rate Demand Bonds

Although bondholders may redeem a demand bond at any time, they are often encouraged to keep these bonds in order to continue receiving coupon payments. The floating rate of the coupon payment contributes to greater uncertainty in coupon cash flows compared to generic municipal bonds, although some of this risk may be mitigated by a redemption option.

Municipal bonds are issued by state and local governments to raise capital to finance public projects, such as building hospitals, highways, and schools. In return for lending the municipalities money, investors are paid periodic interest in the form of coupons for the duration of the bond’s term. At maturity, the governmental issuer repays the face value of the bond to the bondholders.

Some muni bonds have fixed coupons, while others are variable. Muni bonds with floating coupon rates are called variable-rate demand bonds. The interest rates on these bonds generally are reset daily, weekly, or monthly. The bonds are issued for long-term financing with maturities ranging from 20 to 30 years.

In addition, variable-rate demand bonds require a form of liquidity in the event of a failed remarketing. The liquidity facility used to enhance the issuer's credit could be a letter of credit, standby bond purchase agreement (BPA), or self-liquidity, all of which assist in making these securities eligible for money market funds.

For instance, a letter of credit provides an unconditional commitment by a bank to pay investors the principal and interest on the variable-rate demand bonds in the event of default, bankruptcy, or a downgrade of the issuer. As long as the financial institution providing the letter of credit is solvent, the investor will receive payment.

The Early Redemption Option

Variable-rate demand bonds are often issued with an embedded put feature that allows bondholders to tender the issues back to the issuing entity on the interest reset date. The put price is par plus accrued interest. The bondholders must provide notice to the tender agent by a specified number of days prior to the date that the debt securities will be tendered.

A variable-rate demand bond would normally be put, or exercised, if the holder wants immediate access to their funds, or if market interest rates in the economy have increased to a level at which the current coupon rate on the bond is not attractive.

If the bond is tendered prior to maturity because of an increase in rates, the remarketing agent will set a new, higher rate for the bond. If market rates fall below the coupon rate, the agent will reset the rate at the lowest rate that would avoid having a put exercised on the bond.