Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

VRDOs: The safe, liquid, and tax-free municipal

Variable Rate Demand Obligations

Municipal bonds, which are debt securities issued by state and local governments or their agencies, often have the benefit of being exempt from federal and, in some cases, state and local taxes. This treatment can be quite beneficial for investors with a high level of income, or with large taxable investment accounts. One particular municipal security that can provide investors with safe, liquid, and tax-free returns is a variable rate demand obligation (VRDO).

VDROs are long term municipal bonds purchased at par value with a variable interest rate that generally resets on a weekly basis. This variable rate characteristic effectively eliminates any interest rate risk of the security to the holder. In addition, VRDOs come with a “put” feature that allows the bond to be tendered at par plus any accrued interest with seven days notice. This results in VRDOs being extremely liquid securities, on a level similar to short term treasuries or commercial paper. VRDOs are supported by a letter of credit from a major commercial bank which provides both liquidity and security. The bonds can be put to a remarketing agent (generally a bank or other financial institution) who essentially acts as a market maker for VDROs, repurchasing them from clients who exercise the put feature, and holding the securities in their inventory until they are able to resell them to a different client. Because they are backed by a letter of credit from a high grade institution, VRDOs receive high credit ratings from S&P and Moody’s, allowing them to be used in short-term investment vehicles, such as tax-exempt money market funds.

As they are relatively riskless securities, VRDOs generally are not high yielding assets. The SIFMA Municipal Swap Index, which measures the average market value of VRDOs, had a yield of 0.16% (as of Nov. 28, 2012). However, higher yields can be achieved through VRDOs funds, and it is important to remember that the return from these securities is tax-exempt. For this reason, along with the fact that they are liquid, highly rated, and have almost no interest rate risk, VRDOs can serve as a safe, short term component of a fixed income portfolio, particularly in a taxable account.

Tags: , ,

About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

No comments yet.

Leave a Comment