VRDO: The Way To Go

by on September 30, 2009 | ETFs Mentioned:

The development of the ETF industry has in many ways leveled the investing playing field, bringing strategies previously available only to large institutions and sophisticated, high net worth investors to anyone with a Scottrade account. Most of these “democratizations” have involved very complex, high-risk tactics. Leveraged ETFs, hedge fund ETFs, and long/short ETFs have significantly expanded the investment options available to “average” investors.

Hall County Courthouse In Gainesville, Georgia, an Issuer of VRDOs Held By PVIBut ETFs have also opened the door to more conservative fixed income investment strategies ordinarily reserved for financial institutions and corporations. With the introduction of the SPDR S&P VRDO Municipal Bond ETF (VRD) last week, there are now two ETFs offering exposure to variable rate demand obligations (VRDOs), instruments previously only available for large institutions able to deal in large trading denominations (usually $100,000). For a more complete look into ETFs offering exposure to previously unattainable investment strategies, see our Guide to ETFs for Very High Net Worth Individuals.

VDROs 101

VRDOs are typically issued with long-dated maturities of 20 or 30 years, but maintain a feature that allows investors to put them to a remarketing agent at par value plus any accrued interest. VRDOs are municipal securities, meaning that they are tax-exempt and can offer superior returns for investors in high tax brackets. Interest rates on VRDOs generally reset on a daily, weekly, or monthly basis, essentially eliminating any risk associated with rising rates. This feature, along with the put option, effectively make VRDOs short-term securities.

VRDOs maintain minimal credit risk for a number of reasons. First, the put feature allows investors to cash in their security at any time and receive face value. Second, most VRDOs come with a letter of credit provided by a highly-rated bank that adds an additional layer of credit enhancement. The bank serves as a liquidity provider of last resort, and the bank’s credit rating is often assigned to the bond in place of the rating of the issuer.

Benefits Of VRDOs

The high levels of liquidity, high credit quality, and tax-exempt status of VRDOs have made them extremely popular among all sorts of investors. For investors in high tax brackets, the tax-exempt status offers incremental returns not available from other taxable fixed income ETFs. For an investor in the 35% tax bracket, a tax-exempt investment yielding 5% is equivalent to a 7.7% taxable yield.

Even for investors outside the highest tax bracket, VRDOs can offer attractive returns for investors looking to park some assets in a relatively secure place. Because of the credit enhancements typically included with these instruments, the inherent credit risk is minimal. But the returns can be significantly higher than those currently offered by short term Treasuries. The PowerShares VRDO Tax-Free Weekly Portfolio (PVI) was recently offering a 30-day SEC yield of 0.79%, more than three times the 0.22% yield on the Barclays Short Treasury Bond Fund (SHV), which invests primarily in Treasuries with maturities of less than one year. These returns might not sound like much, but for investors looking to allocate part of their portfolios to low risk investments, the dollar difference over time can be material.

From the issuers perspective, VRDOs essentially provide long-term financing at short-term rates, an attractive option in almost every environment.

VRDO ETF Options

PVI launched in 2007, and has become one of the most popular municipal bond ETFs on the market. As credit quality has become an increasingly important consideration for investors, PVI has swelled in size. The ETF has seen cash inflows of $726 million through August 2009, and recently had a market capitalization of more than $1 billion.

Perhaps encouraged by the success of PVI, State Street recently launched the second ETF offering exposure to VRDOs, the SPDR S&P VRDO Municipal Bond ETF (VRD). A comparison of these ETF options is presented below.

Ticker ETF Avg. Credit Quality Avg. Coupon Expense Ratio Avg. Daily Volume
PVI PowerShares VRDO Tax-Free Weekly Portfolio Aa2 1.05% 0.25% 462,000
VRD SPDR S&P VRDO Municipal Bond ETF Aa2 0.60% 0.20% 4,600
Source: Issuer web sites

For more reading on VRDOs, check out this VRDO Primer (PDF).

Disclosure: No positions at time of writing.