Money fund manager BofA Global Capital Management recently posted another educational piece on money market securities. The one is entitled, "The Variable-Rate Demand Note: A Primer," and the subtitle explains, "This Important Investment Vehicle Enables Cash Investors to Capture the Benefits of Tax-Exempt Bonds without Assuming Excessive Risk." Senior Fixed Income Analyst Susan Dushock writes, "The weak economy and resulting shortfalls in tax revenue have left many states and municipalities facing substantial budget deficits. These fiscal challenges and the attendant drops in issuer credit ratings have raised concerns among investors about the suitability of tax-exempt bonds for cash portfolios."
She explains, "While investors are well aware of the risks presented by today's difficult fiscal environment, they likely are less familiar with a widely used tool to address those risks, the variable-rate demand note (VRDN). VRDNs effectively convert long-term municipal bonds into short-term, highly liquid instruments that are appropriate for cash portfolios. They do so through two important features: Periodic interest rate resets (usually daily or weekly), which ensure that the yields on VRDNs reflect the current interest rate environment. Liquidity facilities –- typically provided by highly rated financial institutions –- that allow investors to 'put' the VRDN at par value prior to the maturity date. By making the instrument more liquid than the underlying municipal security, the VRDN changes the risk profile of the issue, enabling the portfolio managers to deliver the tax advantages and diversification benefits presented by municipal bonds to cash investors."
DuShock says, "As noted above, defining features of a VRDN are its variable rate (through the rate reset) and the put feature. The put feature is particularly significant because it enables the manager of a money market fund or other cash portfolio to quickly exit an investment.... The provider of the liquidity facility is effectively the buyer of last resort for the VRDN, enabling the manager to exit the investment even if market conditions are not conducive to a sale."
She cautions, "It is important to note that a VRDN's put feature can be negated if certain events occur. These events, known as 'tender option termination events,' include: The failure of the issuer and credit facility to make interest and principal payments on the bonds or other bonds with the same security; The bankruptcy of the issuer; The lowering of the VRDN’s credit rating by all of the ratings agencies; [and] The revocation of a credit's tax-exempt status by the Internal Revenue Service. These events do not occur often, but when they do, they void the put feature."
DuShock adds, "This is why many VRDNs feature a second safeguard: the direct-pay letter of credit (LOC). Issued by a highly rated financial institution, a direct-pay LOC obligates the provider to pay principal and interest to bondholders. The LOC provider is reimbursed by the obligor of the bond within a certain time frame delineated in the bond documents. The provider of the LOC must meet its obligations even if the issuer of the VRDN fails to reimburse the LOC provider. Not all VRDNs include a LOC, but almost all of the VRDNs in BofA Global Capital Management's cash portfolios have the added protection of direct-pay letters of credit."
Finally, she writes, "For cash investors, VRDNs make it possible to capture the diversification benefits and the tax advantages offered by municipal bonds, while addressing the risks that otherwise would make tax-exempt securities unsuitable for cash portfolios. Indeed, the liquidity facility and the direct-pay letter of credit features enable cash investors to tap the tax-exempt bond market by addressing the central threats to the viability of short-term debt portfolios: the absence of liquidity and the loss of principal."
