In his latest "Arrowhead Weekly" publication, Arrowhead Credit Research Corp. Director of Research Barry Weiss writes, "We discuss States specifically and their credit issues below in this week's spotlight.... I thought we could take a ... look at what has over the past year become a very popular investment trend in the cash sector, and how large Muni debt has become in the taxable, short-end world. The instrument I am thinking of is Variable Rate Demand Notes (VRDNs), which have become a very popular investment for cash managers over the past two years."

Arrowhead's Weekly continues, "Before this newfound popularity began, VRDNs were primarily the play things of tax-exempt managers. But when the markets began to crater, spreads on VRDN's widened to levels considered relatively cheap to what they had been historically to LIBOR, and managers found that only discomfort awaited them in the unsecured commercial paper market. As such, managers embraced VRDNs as a nontraditional addition to their taxable funds. How do you recognize a VRDN in a portfolio? Some managers identify them as such, but others do not, instead referring to them as municipal debt or even as finance/banking in cases where taxable versions of VRDNs are purchased."

Weiss says, "To be clear, as an investment, VRDNs are not necessarily improper and can be a nice diversification play. But like any investment, too much of something can mean a lack of proper diversification and worse, VRDNs are not the boring, mundane Muni debt investments many think they are. Not all VRDNs are the same, and that is partly what makes VRDNs a bit more dangerous than most realize. There is a high degree of complexity in the structure of any VRDN, the underlying credit is not generally the most creditworthy of municipal issuers (they tend to be entities rated below A- and many times are unrated), and the structure not only contains administrative and operational risks but there can be a high degree of potential basis risk."

He explains, "VRDNs are generally structured so that a lower rated Muni debt issuer will pay for a conditional or unconditional support facility provided by a highly rated institution, with a demand or put feature. Once an investor utilizes the put, a remarketing agent is notified, and that agent has a set time to resell the bonds. If a resell failure occurs, it is up to the tender agent to purchase the securities, drawing on the support facilities if need be. A final piece of complexity, VRDNs tend to use the Bond Market Association (BMA) index for reset levels, not the LIBOR many financial participants focus on.... VRDNs are not simple and there are many places where things can get uncomfortably complicated."

Arrowhead writes, "Working from the bottom up, the underlying credit is most likely not a highly rated or maybe not even a rated entity. Given it is highly unlikely that managers analyze the underlying credits, support facilities are of utmost importance. Here too, however, there is plenty of risk, complexity and in the end, not as much diversification as it would seem. Support generally comes in two forms: a Letter of Credit (LOC), an irrevocable and unconditional guarantee; or a Stand By Bond Purchase Agreement (SBPA), a conditional facility."

Finally, Weiss says, "As stated, many consider this type of instrument a safe, mundane play. But while I don't necessarily consider them aggressive instruments, they are not as plain vanilla as it would seem. If the support is structured in the proper manner, and the provider is a strong credit, the trade idea, assuming some yield pick-up can be worth the sizable transactional, basis and operational risks. But risks are aplenty, and diversification is not as beneficial as one expects at first blush."

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