2.2.2.3 Variable-Rate Debt

2.2.2.3 Variable-Rate Debt

The interest rate on variable rate debt is periodically reset in accordance with the terms under which the debt has been issued, and the rate of interest payable on the outstanding debt will rise and fall over the term of the issue with the rise and fall of interest rates generally. Variable rate municipal debt is generally sold to institutional investors in minimum denominations of $100,000 or more and interest is payable more frequently than with fixed rate debt, usually monthly. There is generally no benefit providing for serial bonds, and variable rate debt is generally issued as a single maturity with monthly, twice per year, or annual mandatory sinking fund payments. Most variable rate debt structures require additional support in the form of liquidity providers or credit enhancements. See Section 2.3.2, Credit Enhancement and Liquidity Support.

VARIABLE RATE DEBT VS. FIXED RATE DEBT ADVANTAGES – The principal advantages of variable rate debt are as follows:

  • Lower rates. Unless interest rates increase significantly, the interest payable on variable rate debt over the life of the issue (even including credit, liquidity, and remarketing costs) will be less than the interest payable on fixed rate debt.65

  • Lower initial underwriting costs. Variable rate debt is sold into the short term debt market and the “take down” (sales compensation to the underwriter) is significantly lower for short term debt than for long term debt.

  • Redemption flexibility. Because the value of variable rate debt is rarely more than par (and with VRDOs [variable rate demand obligations] the interest rate is set to establish the value of the debt at par) investors do not require any or much call protection and the issuer may have much greater flexibility to prepay or refinance the debt. See Chapter 3, Types of Debt Obligations Issued by Public Agencies.

VARIABLE RATE DEBT VS. FIXED RATE DEBT DISADVANTAGES – The principal disadvantages with variable rate debt are the additional risks described below:

  • Interest rate risk. An increase in the interest rate on variable rate debt can arise from these factors:
    • General increase in market interest rates

    • Changes affecting the value of tax exempt debt versus taxable debt, including changes in income tax rates

    • Changes in the tax characterization of the particular variable rate obligation, such as a questioning of the tax exempt status of interest on that or similar obligations

    • Changes in the credit of either the issuer or of the provider of liquidity support or credit enhancement for the obligations
Figure 2-1
BASIC CASH FLOW FOR A VARIABLE-RATE DEMAND OBLIGATION OR “VRDO”
Figure
  • Renewal risk. Liquidity support and, apart from bond insurance, credit enhancement is generally not available for the entire term of the obligations and must be periodically extended or replaced. At the time of renewal, liquidity support or credit enhancement may not be available or may be significantly more expensive, either because of changes in the liquidity support/credit enhancement market or because of changes to the issuer’s credit.

  • Default/acceleration risk. Liquidity support and credit enhancement providers generally require the ability to require a tender of variable rate obligations for purchase upon the occurrence of a “default” with a lower threshold than for a default that would trigger the acceleration of fixed rate debt. See Section 2.4.8, Events of Default and Remedies.

The risks associated with variable rate debt may be mitigated somewhat if an issuer’s variable rate debt is a limited portion of the issuer’s debt or if the issuer has a large investment portfolio, with the short term investment of assets providing a natural hedge to a variable rate cost of debt.

LIMITATIONS BASED ON PAYMENT SOURCE – Variable rate debt is not generally a practical alternative if an issuer has limited flexibility with respect to the revenues to be used to repay the debt, such as with general obligation bonds, assessment bonds, or tax allocation bonds. Although lease financings can be done as variable rate obligations, the “fair rental value” requirement of the Lease Exception to the constitutional debt limit can add significant complexity. See Section 3.4, Interest Rate and Payment Terms.