A demand bond is a long-term debt security that gives the holder the right to sell it back to the issuer at full face value on short notice, usually daily or weekly, even though the bond itself may not mature for 20 or 30 years. In municipal finance, these instruments are called Variable Rate Demand Obligations, or VRDOs, and they behave like cash equivalents because the embedded “put option” keeps the price pinned at par.1Municipal Securities Rulemaking Board. About Municipal Variable Rate Securities Three parties keep the structure running: a remarketing agent resets the interest rate, a bank stands behind the put through a separate liquidity agreement, and the issuer pays the underlying debt service.
VRDOs are typically sold in minimum denominations of $100,000, which puts them squarely in institutional territory.2Municipal Securities Rulemaking Board. Interest Payments Money market funds are the dominant buyers, though high-net-worth individuals and corporate treasurers also hold them.
The Put Option and How Tendering Works
The put option is what makes a demand bond a demand bond. It gives the holder a contractual right to sell the security back at par plus accrued interest on any scheduled demand date. Exercising that right is called “tendering” the bond.
The tender schedule depends on the reset mode. In weekly mode, the bondholder typically must provide seven days’ written notice before the next reset date. In daily mode, the turnaround is same-day or next-business-day. The bond’s official statement spells out the exact notice requirements, and missing the window means waiting for the next demand date.
From the investor’s side, this compresses credit risk to a very short horizon. A holder in weekly mode is exposed to the issuer’s creditworthiness only until the next weekly put date, not for the bond’s remaining 25-year life. That short risk window is the reason money market funds can hold these instruments alongside Treasury bills and commercial paper.
The value of the put depends entirely on who stands behind it. The bondholder is not relying on the municipality to come up with cash on a day’s notice. A third-party bank guarantees the purchase through a separate liquidity agreement, and that guarantee is what makes the tender right credible.
Why the Interest Rate Floats
VRDOs carry a floating rate by design. A fixed coupon on a putable bond would create constant tension between price and yield, and bondholders would either tender en masse when rates rose or hold for above-market returns when rates fell. A rate that adjusts to current market conditions keeps the price stable at par.
A remarketing agent, appointed by the issuer, sets the rate on each reset date. The agent surveys the short-term tax-exempt money market and picks a rate just high enough to attract buyers for any bonds being tendered. For tax-exempt VRDOs, that rate is benchmarked against the SIFMA Municipal Swap Index, which tracks weekly resets on high-grade tax-exempt variable rate instruments.3SIFMA. About the Municipal Swap Index Taxable VRDOs, which are less common, now typically reference the Secured Overnight Financing Rate after the discontinuation of LIBOR.
The indenture sets a maximum rate cap that protects the issuer if short-term rates spike. These caps sit well above normal market rates. A floor rate may also apply but rarely matters in practice.
The Remarketing Process
When a bondholder tenders a VRDO, the remarketing agent’s job is to find a replacement buyer before the settlement deadline, usually the same business day. If the agent succeeds, the outgoing investor gets paid with the incoming investor’s money, and the bond simply changes hands. The new holder inherits the same put option and the same floating rate.
In normal markets, this process is invisible. Remarketing agents handle daily flows of tenders and purchases as money market funds routinely reshuffle their holdings. The bond recycles continuously without the issuer or the liquidity provider ever needing to get involved.
A “failed remarketing” happens when the agent cannot place tendered bonds with a new buyer at any rate up to the cap. This can occur during broad market disruptions, after a credit downgrade of the issuer or the liquidity provider, or when the rate being offered simply is not competitive. Failed remarketings are rare in calm markets but cluster during periods of financial stress.
The Bank Behind the Put
The liquidity provider is the entity that makes the put option credible. This role is filled by a highly rated commercial bank under one of two contracts: a Standby Bond Purchase Agreement (SBPA) or a Letter of Credit (LOC).1Municipal Securities Rulemaking Board. About Municipal Variable Rate Securities The distinction matters because the two structures offer different levels of protection.
An LOC is an unconditional commitment by the bank to pay both principal and interest, even if the issuer defaults or goes bankrupt. VRDOs backed by an LOC carry both long-term and short-term credit ratings based on the bank’s own ratings rather than the issuer’s. An SBPA commits the bank to purchase bonds that fail remarketing, but the long-term credit rating still reflects the issuer while the short-term rating reflects the bank.1Municipal Securities Rulemaking Board. About Municipal Variable Rate Securities
In either case, when a remarketing fails, the bank purchases the tendered bonds at par plus accrued interest, so the exiting investor gets paid on time. The bank’s obligation carries narrow exceptions known as “draw-stop” events, which include the issuer’s bankruptcy or insolvency, a downgrade of the issuer below investment grade, a payment default, or a determination that the bonds are taxable.1Municipal Securities Rulemaking Board. About Municipal Variable Rate Securities Outside those extreme scenarios, the bank must pay.
Once the bank does purchase bonds through the facility, those securities become “bank bonds.” The floating public rate is replaced by a higher bank-held rate, and the issuer owes the bank directly on an accelerated repayment schedule until the bonds are remarketed back to public investors. The liquidity facility itself has its own expiration date, typically three to five years, far shorter than the bond’s final maturity. If the issuer cannot renew or replace it, the bonds usually face a mandatory tender, or the issuer must convert them out of variable-rate mode entirely.4S&P Global. Credit FAQ: Navigating a Rise in Variable-Rate Demand Bonds Across US Public Finance Sectors
Tax Treatment
Most VRDOs are issued by state and local governments, and the interest is excluded from federal gross income under Section 103 of the Internal Revenue Code.5Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds That tax exemption is why VRDO yields can sit well below comparable taxable money market rates while still delivering competitive after-tax returns.
The exemption does not cover every municipal bond. Private activity bonds that are not “qualified bonds,” arbitrage bonds, and bonds not issued in registered form all lose the exclusion.5Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds The official statement will confirm the bond’s tax status.
An investor holding a VRDO issued within their state of residence may also owe no state or local income tax on the interest, creating a “triple-tax-exempt” yield. The tax exemption applies only to interest, not to the return of principal when the bond is tendered.
Who Actually Buys Demand Bonds
Money market funds are the natural home for these instruments. Under SEC Rule 2a-7, which governs money market funds, a long-term variable rate security with a demand feature is treated as having a maturity equal to the longer of the period until the next rate reset or the period until the holder can recover principal through the put option.6eCFR. 17 CFR 270.2a-7 – Money Market Funds A weekly-reset VRDO with a weekly put counts as a seven-day maturity instrument for regulatory purposes, even though the bond itself matures in 2050.
This treatment allows money market funds to hold VRDOs while maintaining a stable net asset value. The fund can meet redemption requests by tendering bonds at par on the next demand date. For the security to count as a “daily liquid asset” under the rule, the demand feature must be exercisable and payable within one business day.6eCFR. 17 CFR 270.2a-7 – Money Market Funds
For individual investors, VRDOs are a harder fit. The $100,000 minimum is a barrier, and the floating rate means the income stream shifts constantly. Still, for a high-bracket taxpayer looking for a liquid, tax-advantaged place to park cash, they can work. Unlike a conventional long-term municipal bond, a VRDO does not lose value when rates rise; the coupon simply adjusts upward on the next reset.
Key Risks
The common misconception is that demand bonds are risk-free because they trade at par. They are low-risk in practice, but the risk is not zero, and it concentrates in places that are not obvious.
- Liquidity provider downgrade. The put option is only as good as the bank behind it. If the bank’s short-term rating drops, VRDOs backed by that bank may become ineligible for money market funds, and the resulting wave of tenders can trigger a failed remarketing.
- Draw-stop events. The bank can refuse to honor the put in narrow circumstances: issuer bankruptcy, a downgrade below investment grade, a payment default, or a determination that interest on the bonds is taxable. When a draw-stop is triggered, the holder is left with a long-term bond at whatever rate the market will bear.
- Rate-setting failure. If the remarketing agent sets a rate too low to attract buyers, the remarketing fails. In isolation, the bank steps in. Repeated failures signal deeper credit or market problems, and the issuer’s borrowing costs climb as bonds convert to the higher bank-bond rate.
- Facility expiration. When the liquidity facility expires without a replacement, bondholders typically face a mandatory tender. If the issuer cannot pay, investors may not receive par on the timeline they expect.
The essential task for a VRDO investor is separating short-term from long-term credit risk. The short-term risk of not getting paid on a tender is mitigated by the bank’s SBPA or LOC. The long-term risk belongs to the municipality and matters only when the put option disappears, whether through a draw-stop event, a failed facility renewal, or a mode conversion to fixed rate. In those scenarios, the investor is left holding a long-term bond whose value depends on the municipality’s fiscal health and prevailing interest rates.