A VRDO, or variable rate demand obligation, is a type of municipal bond that pays a floating interest rate instead of a fixed one. Unlike a traditional bond where you lock in a rate for 20 or 30 years, a VRDO’s rate resets at short intervals, typically daily or weekly, based on current market conditions. The other defining feature: you can sell your VRDO back at face value on short notice, giving you liquidity that most long-term bonds don’t offer.
VRDOs occupy an unusual spot in the bond market. They’re technically long-term debt for the issuer (a city, state agency, or other public entity), but they behave like short-term investments for the people who hold them. That combination makes them popular with money market funds and institutional investors looking for tax-exempt income with minimal interest rate risk.
How the Interest Rate Works
The interest rate on a VRDO adjusts at set intervals, most commonly daily or weekly, though some reset monthly. The rate is determined through one of two methods: it’s either tied to an index of short-term municipal rates, or it’s set by a remarketing agent (a broker-dealer firm hired by the bond issuer) at whatever rate is needed to attract buyers at par value. In practice, the remarketing agent plays a central role. Their job is to find the lowest rate that keeps investors willing to hold the bonds.
Because the rate resets so frequently, VRDOs tend to yield in the same neighborhood as other short-term tax-exempt instruments. When short-term rates rise, your VRDO rate adjusts upward quickly. When rates fall, so does your income. This is the tradeoff for the flexibility: you’re protected from being stuck with a below-market rate, but you also don’t lock in a high rate when conditions are favorable.
The Put Feature
The “demand” part of the name refers to the investor’s right to “put” or tender the bonds back, essentially demanding repayment at par value plus any accrued interest. Depending on the terms, you can typically do this on any rate reset date with proper notice. For a weekly reset VRDO, that means you can exit your position every seven days.
This put feature is what makes VRDOs feel like short-term investments even though the underlying bonds may not mature for decades. It’s also what creates the need for a behind-the-scenes support structure that most bond investors never think about.
The Remarketing Process
When an investor tenders their bonds, the remarketing agent tries to find new buyers. They set the interest rate at whatever level (up to a contractual maximum) allows them to sell the bonds to new investors at face value. This is generally a “best efforts” arrangement, meaning the remarketing agent will try to find buyers but isn’t personally obligated to purchase the bonds if no one else will.
In some cases, when an entire series of bonds is being remarketed, the remarketing agent may “underwrite” the deal, agreeing to buy the bonds outright whether or not new investors have been lined up. But for individual investor tenders on VRDOs, the agent simply does their best to match sellers with buyers.
What Happens If No Buyer Is Found
This is where the liquidity backstop comes in. Because investors need confidence that they’ll actually get their money when they tender, most VRDOs are backed by a bank letter of credit (LOC) or a standby bond purchase agreement (SBPA). If the remarketing agent can’t find new buyers for tendered bonds, the bank steps in and purchases them using the LOC or credit line. The issuer then owes the bank for that purchase.
Issuers with very strong credit ratings may not need this backstop, but most do. For investors, the credit quality of the bank providing the LOC or SBPA effectively becomes the credit rating of the VRDO itself. A strong bank backing means a highly rated, easy-to-sell security. A weaker bank means higher risk and potentially higher rates.
Tax Treatment
Most VRDOs are issued by municipalities and public agencies, which means the interest income is typically exempt from federal income tax. Depending on your state, interest may also be exempt from state and local taxes if the issuer is in the same state where you live. This tax-exempt status is a major draw. Because bondholders don’t owe taxes on the interest, they’re willing to accept lower yields than they would on comparable taxable investments.
There are some exceptions. The IRS prohibits certain holders from claiming the tax exemption, particularly entities that are substantial users of the facilities financed by the bonds. If a hospital system issues VRDOs to fund construction and then buys some of those same bonds, for instance, it can’t exclude the interest from its taxable income.
Risks to Be Aware Of
VRDOs are generally considered low-risk investments, but they’re not risk-free. The Municipal Securities Rulemaking Board identifies three primary concerns.
- Remarketing risk: The remarketing agent may be unable to find new buyers for tendered bonds. Since the agent has no obligation to purchase VRDOs itself, a failed remarketing triggers a draw on the liquidity facility.
- Liquidity risk: If remarketing fails, everything depends on the bank honoring its letter of credit or standby purchase agreement. If the bank itself is in financial trouble, it may not be able to follow through.
- Credit risk: The VRDO’s effective credit rating is tied to the bank providing liquidity support. If the bank’s credit quality deteriorates, the VRDO becomes harder to sell and may require higher rates to attract investors.
These risks aren’t just theoretical. During the 2008 financial crisis, the Lehman Brothers bankruptcy raised serious doubts about whether liquidity providers could meet their commitments. Investors rushed to tender their VRDOs, and average rates spiked to around 8% in late September 2008 as the market seized up. The episode demonstrated that even securities designed for safety and liquidity can behave unpredictably when the institutions backing them come under stress.
Who Typically Invests in VRDOs
VRDOs are primarily held by institutional investors, especially tax-exempt money market funds. Their combination of daily or weekly liquidity, par-value put rights, and tax-exempt income makes them an ideal fit for funds that need stable, highly liquid holdings. Individual investors generally access VRDOs indirectly through money market funds rather than buying them on their own, partly because minimum denominations tend to be large and partly because the remarketing and tender mechanics are more suited to institutional portfolios.
For issuers, VRDOs offer the benefit of long-term financing at short-term rates, which are usually lower. The tradeoff is the ongoing cost of maintaining the remarketing agent and liquidity facility, plus the risk that short-term rates could rise significantly over time, increasing their borrowing costs in ways a fixed-rate bond wouldn’t.