For fixed income investors, cash truly is king these days. Thanks to rising rates, cash and cash-like securities have moved from the back burner to the forefront becoming a real source of return for portfolios. However, not all cash-like securities are the same. And only one can provide the trifecta of stability, inflation protection and tax-free income.
We’re talking about the humble variable rate demand obligation or VRDO.
A cornerstone of the municipal bond market, these quasi short- and long-term securities have basically been ignored by investors over the last few years as rates have been close to zero. But now, VRDOs are quickly garnering attention – and rightfully so. For fixed income investors looking for a good yield on their cash holdings while minimizing taxes, VRDOs make a ton of sense.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
A Big Source of Municipal Funding
Municipal bonds have long been a staple of fixed income investors and high income earners’ portfolios. Munis are issued by state and local governments to fund projects and generate revenues. The win for municipal bond holders is that the interest income generated by them is free from federal and state taxes if the bond is issued by the holder’s home state.
One of the problems with investing in munis is that they are generally a long-dated bond issued in 20- or 30-year maturity profiles, which makes them subject to interest rate risks. Variable Rate Demand Obligations (VRDOs), sometimes called Variable Rate Demand Notes (VRDNs), look to circumvent this long-term maturity profile and provide interest rate protection.
VRDOs are issued by states and local governments just like any other muni bond. And just like any other municipal bond they have maturity profiles of 20 to 30 years. Where VRDOs differ is in their interest rates and a special “put” option embedded in each bond.
As their name implies, VRDOs have a variable coupon that adjusts to changes in interest rates. Typically, this rate changes every 7 or 35 days depending on the bond. So as the Fed raises rates, so does the distribution from each VRDO.
The other differentiating factor with VRDOs and regular muni bonds remains their ability to be “put” back and redeemed early by investors. This is the “demand obligation” part of their name. Every VRDO includes a one or seven day option for investors to hand the bond back to an agent, called a Tender Agent. To make sure the bonds are able to be sold at par when placed with the transfer agent, muni issuers will use Letters of Credits or insurance to guarantee that investors are made whole.
With a VRDO, municipalities are able to borrow funds with long maturities while paying investors short-term rates.
The Benefits of VRDOs
For investors, the benefits of VRDOs are threefold.
For starters, the variable rate of interest allows investors to protect their portfolios from inflation and rising rates. Because their coupons are tied to measures like LIBOR and other short-term lending rates, VRDOs pay more interest in rising rate environments. This is different from a standard muni bond which features a fixed coupon payment.
Secondly, the put option allows VRDOs to function like holding cash. With the ability to put back the VRDO at par in as little as a day, the bond type features plenty of liquidity.
Finally, as a municipal security, VRDOs feature the same tax treatment as their regular muni bond cousins, meaning they are free from federal taxes and potentially state taxes as well. While we haven’t had to think about paying taxes on interest income from our savings accounts in years, 2023 could be a different story given the higher yields on cash products. This makes VRDOs a top pick for many investors.
Adding VRDOs to Your Fixed Income Sleeve
Given the benefits of using VRDOs in a portfolio, investors may want to consider them. The problem is that most VRDOs are issued in increments of $100,000 each. With that hefty starting price, building a portfolio of VRDOs really only makes sense for high-net-worth individuals. But us regular Joes also have options when it comes to the asset class.
For starters, there are municipal money market mutual funds. More than 75% of all the VRDOs issued are held by municipal money market funds. These funds function just like a regular money market fund, featuring a stable $1 share price, liquidity and monthly interest payments. Pretty much every major mutual fund company has one in its roster. Investors in high tax states may want to use one from their hometown. For example, the Vanguard New York Municipal Money Market Fund (VYFXX) or Fidelity California Municipal Money Market Fund (FABXX)
Another option? Exchange-traded funds (ETFs).
The largest in the space is the $475 million iShares Short Maturity Municipal Bond ETF (MEAR), which holds roughly 40% of its assets in VRDOs and functions like a cash product. For a pure-play option, the Invesco VRDO Tax-Free ETF (PVI) is really the only game in town.
In the end, adding a dose of VRDOs via a muni money market fund or through an ETF can provide a highly liquid source of tax-free income that is protected from inflation. For many investors, the benefits are too good to pass up.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
