Variable Rate Demand Obligations

Municipalities use a wide range of financial instruments in order to borrow funds from the money market. This includes the issuance of short-term debt as well as commercial paper. However, over time they have started using one more type of financial instrument. This instrument is called variable rate demand obligation and is the result of financial innovation happening in the money market.

Over the years, many municipalities have started raising money using variable rate demand obligations. In this article, we will have a closer look at the meaning of variable rate demand obligations as well as the reason behind their issuance.

What are Variable Rate Demand Obligations?

It is common for municipalities to finance long-term liabilities with long-term debt as well as short-term liabilities with short-term debt. The variable rate demand obligations allow municipalities to finance long-term liabilities with short-term debt.

In order to understand variable rate demand obligations, we must split the name of the instrument into two parts.

Let’s first focus on the variable rate part. Variable rate demand obligations are a type of financial instrument where the payable interest rate is not fixed.

Instead, it is a function of a money market interest rate such as the interest payable on short-term treasury bills. Hence, based on the benchmark interest rate, the interest payable to holders of these securities resets periodically.

Now, let’s pay attention to why the words demand obligation is used to describe the security. It needs to be understood that even though technically these securities have a long maturity, they have an embedded put option. This means that at any time, an investor can decide to exercise this option and obtain their money back.

If an investor feels that the interest rate being offered is too low or that the credit quality is deteriorating, they can ask for their money to be paid back. They will have to give a notice period which is either 1 day, 7 days, or 30 days and then the municipality will have to refund their money. Since these fund funds need to be paid back on demand, they are called demand obligations.

Some variable rate demand obligations have a provision that allows the issuer to give notice to all parties and then extinguish the variable rate demand obligations by converting them into fixed-rate outstanding debt which does not have any demand features.

It needs to be noted that variable rate demand obligations are issued in large denominations. It is common for these obligations to be issued in multiples of $25000 or $50000. Hence, these obligations are generally purchased by institutional investors. Retail investors generally are unable to directly invest in such securities.

Why are Variable Rate Demand Obligations Used?

The variable rate demand obligations were introduced in the money market in the 1980s. However, they have grown relatively quickly and are issued in significant quantities now. This is because they provide certain advantages to the issuer. These advantages have been listed below:

1. Issuing and reissuing short-term debt can be an expensive affair. There are several costs that are associated with the number of issues being undertaken. These costs include the legal fees which have to be paid. Also, the services of financial experts have to be utilized repeatedly in order to prepare financial statements which are mandatory before an issue.

   The expenses related to the distribution of this newly created debt also add up thereby increasing the transaction costs. If a municipality issues variable rate demand obligations, then they can simply avoid all these expenses.

2. Secondly, municipal bodies are not private organizations. There is a large bureaucracy in place that needs to be taken into account. Each time, a municipality wants to raise funds it needs the approval of voters as well as several office-bearers. This can be a time-consuming and expensive exercise and also has the potential to turn political at times. When municipalities issue variable rate demand obligations, they can avoid the entire bureaucracy.

3. Municipalities are often subject to debt ceiling which are imposed by the federal government or other such bodies. If they continuously roll over their short-term debt, there is always a chance that they will not be able to issue more debt because the ceiling has been reached.

   In such cases, they could end up facing a financial crisis since it is likely that they would not have the money to pay the loan and would not even be able to raise more funds. This can be avoided by the use of variable rate demand obligations which provides the municipality with the flexibility of paying short-term interest rates as well as extinguishing the debt when it is no longer required.

Hence, it can be said that even though variable rate demand obligations are not very popular with other classes of issuers, they are preferred by municipal issuers. This is because they have certain features which make them more attractive to municipal issuers.