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Variable rate demand notes are akin to auction rate securities with recourse to a fixed income fund of municipal bonds from a given state.
Update - July 16, 2008 - While many auction rate security and variable rate demand note instruments have been retired, returning principal to investors, these instruments are now viewed as highly inappropriate for non-institutional investors. The ARS and Variable Rate Demand Note market has experienced severe difficulty, making front-page news on the Wall Street Journal. Many investors have been unable to liquidate their positions, and yields are highly volatile. Until the market sees greater stabilization and transparency, we recommend staying away from Auction Rate Securities and Variable Rate Demand Notes.
How does a Variable Rate Demand Note Differ from an Auction rate Security?
Since variable rate demand notes are secured against a fund of municipal securities,
income produced is ordinarily tax-free to residents of the state that has issued
the underlying securities. Variable rate demand notes usually trade at a very
slight premium to tax-free auction rate securities as they require a minimum
purchase of $100,000, but then trade in $25,000 increments. Interest on these
securities is ordinarily reset every Wednesday. While rate setting is each week,
interest payments may not be; in those cases, the securities trade with accrued
interest.
New York variable rate demand notes, for example, currently have rates around
3.00%. This rate reflects a slight premium to comparable rates in tax free money
market funds and is attributable to the complexity of the instrument and the
fact that the notes are only available in $100,000 increments. The 3.00% rate
is equivalent to a fully taxable equivalent of approximately 4.50% for taxpayers
in the 35% federal tax bracket (assuming no state or local taxes). For a resident
of New York City, subject to the highest state and local tax in the country,
this rate would be equivalent to a fully taxable return above 4.75%. If you
are in a lower tax bracket, the advantages are less certain with a taxpayer
in a 25% federal tax bracket receiving a fully taxable equivalent of approximately
4.25% (or about 4.50% for a New York City resident).
Compare fully taxable equivalent of a municipal bond in your state and tax bracket.
