What Is Variable-Rate Debt?

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Written By SmarterrMoney.org

The latest in personal finance to help you make smarter money choices. 

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

  1. The issuer’s credit, or 
  2. 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:

  1. Self-liquidate with cash they have on hand, or
  2. 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).