Variable-rate debt is a long-term loan or bond with interest rates that reset on a short-term basis.
Municipalities and Variable-Rate Securities
Interest rates may be reset at periodic intervals or after specified events or conditions.
Rates may be determined by
- The issuer’s credit, or
- A predetermined index, such as the Secured Overnight Financing Rate (“SOFR”) or the SIFMA Municipal Swap Index
The risk for municipalities that issue variable-rate securities is that variable rate debt’s investors can sell the variable rate debt back to the issuer (municipality) whenever a rate change occurs. The issuer would then have to either find a new buyer or redeem (pay off) the security.
The issuer must therefore have access to sufficient funds to pay for securities sold back to them. They can either:
- Self-liquidate with cash they have on hand, or
- Hire a letter-of-credit bank responsible for supplying cash when a bond is returned to the issuer. The issuer then sells the bond back into the open market and repays the letter-of-credit bank with the proceeds.
The variable-rate demand obligation (VRDO) is the most common floating-rate security type. Tax-exempt VRDOs are commonly benchmarked to the SIFMA Municipal Swap Index, formerly called the Bond Market Association (BMA) index, instead of non-tax-exempt indices like LIBOR or other bond indices. In contrast, taxable VRDOs are typically indexed to LIBOR.
What’s important here?
Bonds with interest rates adjusted by a predetermined index are called floating-rate securities or floaters.
Interest rates are reset periodically at some fixed spread above the selected index. The spread, remaining constant throughout the security’s life, might be 2% above the index. Interest rates may be reset daily, weekly, monthly, or annually. Common indices include the SOFR, the federal funds rate, and the Treasury bill rate (3-month, 6-month, and 12-month).