Variable rate demand notes, also known as variable rate demand obligations, are considered a form of short-term municipal debt. When an investor purchases a variable rate demand note, they’re obtaining a variable rate bond with a put option. On a set schedule (usually every few weeks or months), the note resets its interest rate to the current market interest rate. Unlike normal bonds with fixed coupons, variable rate demand notes provide a varying level of interest to their investors.
If the investor is not satisfied with the new interest rate, they can utilize their put option. A put option on a bond allows the bondholder to sell the bond back to the issuer at its par value. Essentially, the investor decides when the investment is finished.
Variable rate demand notes (and anything with a variable coupon) will not be subject to significant market price changes when interest rates fluctuate. If interest rates rise, the investor knows their variable rate demand note will adjust their coupon to a higher rate on the reset day. Also, the bondholder knows the bond can always be put back to the issuer at par. Due to this, the market price of variable rate demand notes does not deviate far from par.
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