DEFINITION of 'Variable Rate Demand Bond'

A variable rate demand bond is a municipal bond 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 what is used to set the interest rate, plus or minus a set percentage. As a result of this, the coupon payments can change over time.

BREAKING DOWN 'Variable Rate Demand Bond'

Municipal bonds are issued by state and local governments to raise capital to finance public projects, such as building hospitals, highways, schools, etc. 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.

While some muni bonds have fixed coupons, others are variable. Muni bonds with floating coupon rates are called variable rate demand bonds. These bonds have their interest rates generally reset periodically on a daily, weekly, or monthly basis. 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, 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 a default, bankruptcy, or downgrade of the issuer. As long as the financial institution providing the letter of credit is solvent, the investor will receive payment.

Variable rate demand bonds are 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” if the holder wants immediate access to his or her funds or if market interest rates in the economy have increased to a level in which the current coupon rate on the bond is not attractive. If the bond is tendered prior to maturity due to an increase in rates, the remarketing agent will set a new, higher rate at which a remarketing agent can re-place the Bond. On the other hand, if market rates fall below the coupon rate, the agent will reset the rate at the lowest rate that will avoid a put being exercised on the bond.

Although a demand bond can be redeemed at any time, bondholders are often encouraged to keep the bonds in order to continue receiving coupon payments. The floating rate of the coupon payment contributes to higher uncertainty in coupon cash flows compared to generic bonds. Some of this risk is mitigated by the redemption option.

  1. Coupon Bond

    A coupon bond is a debt obligation with coupons attached that ...
  2. Bond Discount

    Bond discount is the amount by which the market price of a bond ...
  3. Zero-Coupon Bond

    A zero-coupon bond is a debt security that doesn't pay interest ...
  4. Current Coupon Bond

  5. And Interest

    And interest is a slang phrase used when quoting the price of ...
  6. Short Coupon

    A short coupon is a payment made on a bond within a shorter time ...
Related Articles
  1. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

  2. Financial Advisor

    Calculate PV of different bond type with Excel

    To determine the value of a bond today — for a fixed principal (par value) to be repaid in the future — we can use an Excel spreadsheet.
  3. Financial Advisor

    7 Questions to Consider Before Investing in Bonds

  4. Investing

    Six biggest bond risks

  5. Investing

    Corporate Bond Basics: Learn to Invest

  6. Investing

    4 basic things to know about bonds

  1. How do debit spreads impact the trading of options?

  2. What are the risks of investing in a bond?

    Are you thinking of investing in bond market? Learn more about bond market investment risk, including interest rate risk, ... Read Answer >>

    An investor who sells a bond must be compensated in coupon payments for the period they owned the bond, defined as the interest ... Read Answer >>
Trading Center