Municipal variable rate demand obligations (VRDOs) remain an appealing, high-quality cash management tool for institutional portfolios in a yield-starved environment.

Recent FOMC meeting minutes showed that more aggressive tightening policies are likely due to policymakers’ increasing uneasiness with elevated inflation and more robust confidence in the labor market and overall economy. As such, we believe municipal variable rate demand obligation (VRDO) securities have an opportunity to play a more significant role in many institutional and corporate cash portfolios as their attractive yields and unique stable NAV pricing offer significant value relative to other cash-equivalent instruments.

Throughout 2021, various VRDO security structures were available in the new issue and secondary marketplace that carried yields between 20 and 50 basis points. This was quite attractive compared to the one-month T-Bill, one-month LIBOR, and SOFR rates over the same period, which averaged a paltry four to seven basis points, respectively. Like all floating rate instruments, as the Fed Funds rate begins to rise, so will VRDO rates.

While not widely known among traditional fixed income investors, VRDOs make up between 90 – 95% of all tax-exempt money market fund assets, while roughly 95% of the group’s outstanding securities carry the highest short-term ratings of A-1/P-1. The current size of the VRDO marketplace stands at just over $150 billion and has been steadily growing to meet investor demand. Most importantly, VRDOs are purchased and sold at par regardless of market conditions. This is made possible by bank and/or issuer support. This unique feature makes it the only fixed income security structure with a perpetually stable NAV. VRDOs are not to be confused with auction rate securities that can trade below par in the event of a failed auction.

Typical maturity dates on VRDOs range from one to five business days, but other maturity options are available. With 10 of the past 13 years witnessing a fed funds rate stuck at or near zero, increased demand for higher-yielding VRDOs has pushed this money-market-eligible instrument to transform and adapt over time with changes to maturity length and various credit support mechanisms. Most importantly, the basic tenet of a stable NAV has not been sacrificed.

In this historically low-yield environment where every basis point counts, we believe high-quality VRDO securities can play a pivotal role in institutional client portfolios that requires some or all of their assets to be liquid and maintain a stable NAV. With short-term interest rates set to rise, we believe this security structure will offer considerable value in what is expected to be a turbulent market during 2022.