As fixed income investors brace themselves for a rising interest rate environment, various bond fund managers are also seeking alternative ways to hedge against the risk and still produce decent returns to keep up with inflation. Apparently, the U.S. fixed income market has seen some huge capital transfers from bond funds to either money market funds or equities in the recent months.
It’s important to note that it’s easier for individual investors to make appropriate shifts than for bond fund managers. This is because these fund managers are often mandated to stick with the core competency of their funds – a philosophy that makes portfolio rebalancing a daunting task.
Meanwhile, the statistical data compiled by the Securities Industry and Financial Markets Association (SIFMA) suggests that variable rate demand obligation (VRDO) issuance was expected to rise to $8.0 billion in 2016, up from $6.2 billion in 2015. In this article, we will explore the prospects of VRDOs and how they can be viewed as a capital preservation tool in the current economic environment.
Operating Mechanism of a Variable Rate Demand Obligation
VRDOs provide issuers with the ability to access capital market for their long-term capital needs while capitalizing on short-term rates. Like fixed rate municipal debt instruments, VRDOs also have long maturities; however, they come with weekly or daily reset periods.
This reset period is the distinguishing feature of VRDOs, making them the most attractive option for conservative investors. During this reset period an investor can sell the security back to the issuer at par and keep whatever interest they’ve earned. This feature is similar to a put option, making VRDOs behave like short-term securities. Typically, a VRDO issuer would have a remarketing agent, i.e. a bank or other agency that can provide liquidity, as the middleman. When the security is tendered by an investor, this agent looks for another investor for this security and passes on the proceeds to the first investor. If there isn’t an investor to take on the tendered security, the issuer has to reimburse the investor.
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The chart below can be used to better understand the VRDO structure for a municipal debt transaction.
In a low interest rate environment, from an issuer’s perspective, a VRDO can be quite cost effective because municipalities are borrowing long-term debt at short-term interest rates. The credit ratings have also been supportive of VRDOs because of the strength of the financial institutions that back these debt structures. For a better understanding of the performance of variable rate structures, you can refer to the credit reports of the New York Housing Finance Agency Variable Rate Bonds and the Sunnyvale Variable Rate Refunding Certificates.
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In a normal yield curve, short-term rates are always lower than long-term rates; for this reason, municipalities issue VRDOs to capitalize on the short-term rates and diversify their debt structure. Even under a gradually rising interest rate environment, VRDOs can be used in the form of interim financing, wherein these securities will be used to finance a project and will then be refunded with fixed rate long-term debt.
Special features of a VRDO that investors should take note of include:
- Embedded option and liquidity support: The put option or the embedded option is key for any investor or a fund manager investing in VRDOs as a capital preservation tool because it aids in determining the liquidity and the credit quality of the security. VRDOs are supported by either a LOC (Letter of Credit) or SPA (Standby Purchaser) of a financial institution utilized by a municipality. This financial institution is the liquidity provider when an investor tenders the securities back to the issuer. This provides an extra layer of security and peace of mind for investors to know that there is an institutional trustee to facilitate the sale of their security during the reset period. However, municipalities that hold healthy liquid reserves and also have strong credit ratings can also act as liquidity providers for their own VRDO transactions.
- Changing coupon with prevailing rates: In the case of a VRDO, its coupon rate resets to the prevailing interest rates after every reset period. This means that investors who continue to hold their securities will not receive the same coupon payment and the income might decline if interest rates follow a declining trend.
Explore other key economic indicators that you need to track while investing in different types of muni bonds, including VRDOs.
Risks Associated with VRDO Investments
Although VRDOs are generally considered low-risk investment options to provide high liquidity and tax benefits, there are still some risks associated with these investments that investors should consider, such as the ones listed below.
- Credit Risk: As a form of added security, municipalities, when issuing VRDOs, will utilize LOC or Bond Purchase Agreements from a liquidity provider with a high credit worthiness to handle such transactions. This can serve as a guarantee for investors when they sell their securities back during the reset periods; however, there is always the risk of a financial institution not being able to meet its obligations.
- Call & Conversion Risk: As mentioned earlier, municipalities have started using this form of funding for their short-term capital needs or on an interim basis. Once their short-term need is met, they can either refund this debt with fixed income bonds or call the debt in its entirety. In this event, investors will be forced to seek out other investment options that may not be favorable in a declining interest rate environment.
- Reinvestment Risk: The coupon rate on VRDOs is ever changing, meaning that the income will decline in the event of falling interest rates. On the contrary, although fixed rate municipal debt is highly sensitive to interest rate changes, it at least gives investors the assurance that as long as they hold their securities until maturity they will get full face value along with the coupon payments.
The inherent risks in the VRDOs were exemplified during the 2008 financial crisis when interest rates started plummeting to historic lows and continued the trend until 2014. The extremely low coupons on VRDOs caused the incomes to decline, causing investors to flee the market. This had a domino effect on the liquidity providers who faced a severe cash crunch.
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Ways VRDOs Can Help You Preserve Capital
As interest rates are on the rise, VRDOs can be a safe haven for investors. Here are few of the main benefits to keep in mind:
- High Liquidity: As a rising rate environment is bound to have a negative impact on fixed rate debt, VRDOs should thrive. The put option also provides safety and liquidity to both retail and institutional investors besides providing cash flow to fund managers.
- Relatively Low Risk: The majority of VRDOs are backed by a financial institution with a strong credit rating, serving as a type of bond insurance. Moreover, VRDOs tend to mitigate interest rate risks for investors, because they are traded at par during the reset periods. Comparatively, fixed rate debt always carries an inverse relation to interest rates; so, a fixed rate maturity, if traded before its maturity, will lose value if traded in a rising rate environment.
- Favorable Tax-Treatment: Like other municipal debt, VRDOs are also generally exempt from federal income taxes.
The Bottom Line
The rising interest rate environment creates an ideal opportunity for VRDO investors to grow their income streams during the reset periods and to also have much higher liquidity than fixed rate municipal debt. Moreover, as the rates continue to increase, more and more debt investors and fund managers are expected to turn to shorter maturities to diversify their portfolio and improve cash flows.
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