Consider adding VRDOs to your municipal bond allocation to keep duration in check, enhance liquidity and to capture yield increases.
With interest rates remaining historically low, investors are flooding into high yield and longer-dated bonds in a scramble for any extra yield and return they might find. You see this with municipal bond investors, in particular, as of late. Rather than taking the extra risk of duration and lower quality issues, some seasoned muni investors see Variable Rate Demand Obligations (VRDOs) as an attractive opportunity. But there’s a hook…not everybody can afford them.
After peaking in late October, yields on AAA munis have been sinking across the curve and have descended to levels not seen since September of 2017. With muni bonds this expensive, compelling risk/reward opportunities within short maturity, high quality issues are sparse.
Adding VRDOs to a portfolio can help maintain lower duration while boosting credit quality. And, in a rising-rate environment (yes, that is still possible one day), these VRDOs will provide a boost in tax-exempt yield as their stated yields automatically reset on a daily or weekly basis.
What Are Variable Rate Demand Obligations and Why Do Investors Like Them?
VRDOs are tax-exempt debt securities issued by municipalities to secure long-term financing (typically for 20 to 30 years) but at short-term rates. VRDOs trade as short-term municipal money market securities with zero duration.
What Do VRDOs Offer Investors?
- Extra stability—VRDOs benefit from a Letter of Credit (LOC) that pledges repayment of principal and interest should the issuer default on the bonds.
- Enhanced liquidity—Investors can sell a VRDO back at par during specified reset periods, ensuring liquidity and aiding in the stability of capital.
- Variable yield—During the reset period, a VRDO’s coupon rate adjusts to the prevailing interest-rate levels, providing investors with increased levels of interest income during periods of rising rates.
What Are the Risks of VRDOs?
- Potential credit risk of the issuing municipality and LOC provider.
- In a declining interest-rate environment, yields can erode as the VRDO’s interest rate periodically resets to the lower prevailing rates.
- Issuer can call (retire) the bonds early. Along with the put feature that gives investors the right to sell the bond at par, VRDOs have a call feature, which allows the issuer to call the security at par. This often happens during a period when reset rates become unattractively high and the issuer believes they can secure cheaper funding elsewhere in the market.
An Active Municipal Bond Fund Can Be the Best Way to Get Exposure to VRDOs.
The minimum initial buy-in of $100k is too steep for many individual investors to purchase VRDOs directly. For this reason, it makes sense to use an experienced and hands-on muni bond manager to gain exposure to these tax-exempt variable rate securities. An active manager with a proven track record investing across the entire spectrum of municipal bonds may be best able to effectively use VRDOs to deliver the most value to investors, keeping duration and quality in check as interest rates and market dynamics fluctuate.