Variable-Rate Demand Obligations (VRDOs)
In the 1980s, Congress began imposing limits on certain types of bond issues. The Tax Reform Act of 1986, for example, placed a limit on the amount of tax-exempt commercial paper that could be issued by municipalities. Issuers that rolled over their commercial paper were deemed to have issued new debt. Once their debt limits were reached, any new issue would come without tax-exempt status. This would effectively eliminate any additional use of that source of funds. This new restriction led to the creation of variable-rate demand obligations (VRDOs).
VRDOs are floating-rate obligations that have a nominal long-term maturity, but whose interest rates are automatically reset on a daily, weekly, or monthly basis. They also contain a put option, which gives investors the right to put the security back to the issuer at any time, at a price equal to the bond’s face value plus accrued interest. The put option may be exercised after a notification period that normally corresponds to the length of time between interest rate adjustments.
VRDOs are long-term bonds with variable short-term interest rates. The put option allows VRDOs to sidestep the tax reform debt limits because when an investor exercises the put option and puts the bond back to the issuer, the issuer can simply resell the bond to another investor without issuing new debt.
Example: Suppose the port authority in your state issues a $100 million VR