Variable-Rate Demand Notes Now Freezing

Work to rule, banking edition.

Variable rate demand notes [VRNs] were widely considered much more liquid than auction-rate paper:
Variable rate demand notes have some similarities with floating-rate bond. A floating-rate bond carries a fixed spread over a referral index, the spread over LIBOR on a VRN varies over time depending on the change in the perceived credit risk of the issuer. The spread is reset at each rollover date by means of negotiation between the issuer and arranging house.

Liquidity put:

VRNs are usually issued with no maturity date but fixed five-year and longer-dated issues are in existence. VRNs generally have a put option for the existing holders of notes to sell the issue back to the lead manager of the issuing syndicate, at par, at any interest payment date.

Market size:
About $400 bn

From Reuters: Variable-Rate Note Market Now Freezing

UBS (UBS) and Citigroup (C) are not serving as the remarketing agent for some variable rate demand notes, instead asking investors to contact the trustees.

One of the main culprits causing the market for variable-rate demand notes to seize up is the troubled bond insurers that guarantee them. This is the same factor that has caused the $330 billion auction-rate note market to get hit with billions of dollars of failed auctions every day since late January.

As a result, the market for variable-rate demand notes has split in two, with credit-worthy paper at times fetching yields that are lower than the approximately 2.5 percent rate that previously prevailed for most of this debt. Less desirable notes now trade at yields of 6 percent and even higher.

This phenomenon has shocked investors because variable-rate demand notes have safeguards — letters of credit and standby purchase agreements.

Issuers of variable-rate demand notes — including states, cities and towns — paid extra fees to give investors those protections, which oblige the sellers of those guarantees to buy the debt back.

In contrast, auction-rate notes have none of those safeguards, and billions of dollars of auction-rate notes have failed since late January — which means issuers have had to pay penalty rates as high as 20 percent. Such auctions fail when there are not enough buyers.