Why you should consider variable-rate demand obligation bonds

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Variable-rate demand obligations (or VRDOs)

Municipal bonds (or munis) are issued by state and local governments and their agencies to fund capital expenditure on public projects (like highways, bridges, schools, or hospitals). In the last article of this series, we discussed revenue, taxable, and insured bonds. In this article, we’ll discuss another variant of municipal bonds that could see increased demand from investors due to the anticipated future increase in interest rates.

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Variable-rate demand obligations (or VRDOs) are long-term, tax-exempt, floating-rate bonds whose interest rates generally reset on a daily, weekly, or monthly basis. VRDOs are generally purchased at par. VRDOs may have maturities as long as 20 to 30 years but are issued with a put feature. Through the put, investors can sell the bond back to the investment dealer at par plus accrued interest, as applicable. As they’re issued in the primary market at par in $100,000 increments, investing in VRDOs through ETFs would be easier for retail investors. Popular ETFs providing exposure to VRDOs include:

  • The Invesco PowerShares VRDO Tax Free Weekly Portfolio (PVI) tracks the Bloomberg U.S. Municipal AMT-free Weekly VRDO Index. The index comprises municipal securities issued in the primary market as variable-rate demand obligations (VRDOs) whose interest rates are reset weekly. PVI has an expense ratio of 0.25%.
  • The State Street SPDR S&P VRDO Municipal Bond ETF (VRD) tracks the Municipal VRDO Index. The index is a rules-based, market value–weighted index engineered for the municipal variable rate demand obligation bond market. To be included in the Municipal VRDO Index, a security must be issued by a state (including Puerto Rico and U.S. territories) or local government or agency such that interest on the security is exempt from U.S. federal income taxes, be priced at par and have a minimum par amount of $10 million. VRD has an expense ratio of 0.2%.

Why should investors consider investing in VRDOs?

While the returns on both PVI and VRD over the past three years have hardly been compelling (0.51% and 0.35%, respectively), readers should recall that these are floating-rate obligations and interest rates have been at unprecedented lows over the past five years. However, with the Fed indicating that it would look at raising the base rate between Q2 and Q4 2015, interest rates across all maturities are expected to increase. This would benefit VRDOs, as these are floating-rate obligations and investors would get the benefit of rising interest rates in the future.

Which sectors are likely to perform well in a rising rate environment?

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Rising interest rates usually imply economic expansion or higher inflation. In the present case, policymakers face stubbornly low inflation, but economic expansion seems well on track, with GDP growth at above long-term trends, as indicated by the Purchasing Managers Index (or PMI) readings for last month. To learn more about the PMI and how it affects the economy, read the Market Realist series Why do key purchasing managers’ index readings move markets?

The energy and basic materials (commodities) sectors tend to perform well in a rising rate environment. Economic growth implies increased demand for commodities, which increases revenues and earnings for companies in these sectors, all else equal. One ETF investing in the energy sector is the State Street Energy Select ETF (XLE). The top holdings in XLE include Exxon Mobil (XOM) and Chevron (CVX).

Please continue to Part 5 of this series to read about other muni bond variants and investor strategies to benefit from these investments.

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