A demand bond is a long-term debt security that gives the holder the right to sell it back to the issuer at full face value on short notice, often as frequently as once a week or once a day. The bond itself may not mature for 20 or 30 years, but that embedded right, called a put option, makes it behave like a short-term cash instrument. In municipal finance, where demand bonds are most common, they go by the name Variable Rate Demand Obligations, or VRDOs.
The structure exists because state and local governments want to borrow long but pay short-term interest rates, and money market funds want short-term instruments with tax-exempt yields. The demand bond bridges the two.
The Put Option Is the Whole Point
Everything about a demand bond flows from one contractual right: on each scheduled demand date, the holder can hand the bond back and receive par plus accrued interest. Exercising that right is called tendering.
The schedule depends on the bond’s reset mode. In weekly mode, the holder typically must give seven days’ written notice before the next reset date. In daily mode, the turnaround is same-day or next-business-day. The official statement spells out the exact notice requirements, and missing the window means waiting for the next demand date.1Municipal Securities Rulemaking Board. About Municipal Variable Rate Securities
Two consequences follow. First, the market price stays pinned near face value. If the price ever drifted below par, holders would tender and collect in full, so it never drifts far. Second, the holder’s credit exposure to the issuer shrinks from decades down to days. A weekly-mode bondholder cares about the issuer’s creditworthiness only until the next weekly put date, not for the remaining 25-year life of the bond. That short risk window is why money market funds can hold these instruments alongside Treasury bills.
Why the Interest Rate Floats
A fixed coupon on a putable bond would create constant tension between price and yield. Every time market rates moved, the bond’s value would shift, and holders would either tender en masse or hold for above-market returns. A floating rate that adjusts to current conditions keeps the price stable at par and makes the whole mechanism workable.
On each reset date, a remarketing agent appointed by the issuer sets the new rate. The agent surveys the short-term tax-exempt money market and picks a rate just high enough to attract buyers for any bonds being tendered. For tax-exempt VRDOs, that rate is benchmarked against the SIFMA Municipal Swap Index, which tracks weekly resets on high-grade tax-exempt variable rate instruments.2SIFMA. About the Municipal Swap Index Taxable demand bonds, which are less common, now typically reference the Secured Overnight Financing Rate after the discontinuation of LIBOR.
The bond’s indenture sets a maximum rate cap, protecting the issuer from runaway borrowing costs if short-term rates spike. Caps are usually set well above normal market rates.
Who Actually Pays You When You Tender
The credibility of a demand bond depends on the machinery behind the put option. Three separate parties each handle a different piece.
The issuer pays the ongoing interest on the debt. The remarketing agent resets the rate and finds a replacement buyer when someone tenders. And a liquidity provider, almost always a highly rated commercial bank, stands behind the put option itself.
In normal markets, tendering is invisible. A money market fund reshuffles its holdings, the remarketing agent places the bonds with a new buyer within the same business day, the outgoing investor gets paid with the new investor’s money, and the bond simply changes hands. Nobody at the issuer or the bank has to lift a finger.
The bank matters when the recycling breaks down. If the remarketing agent cannot place the tendered bonds with a new buyer at any rate up to the cap, the remarketing has failed. That can happen during broad market disruptions, after a credit downgrade of the issuer or the bank, or when the offered rate is simply not competitive. When it does, the bank is contractually obligated to buy the tendered bonds at par plus accrued interest, so the exiting investor still gets paid on time.
Letter of Credit vs. Standby Bond Purchase Agreement
The bank’s obligation comes through one of two contracts, and the difference matters to investors.1Municipal Securities Rulemaking Board. About Municipal Variable Rate Securities
A Letter of Credit (LOC) is an unconditional commitment by the bank to pay both principal and interest, even if the issuer defaults or goes bankrupt. Bonds backed by an LOC carry both long-term and short-term credit ratings based on the bank’s own ratings, not the issuer’s.
A Standby Bond Purchase Agreement (SBPA) commits the bank to purchase bonds that fail remarketing, but the bond’s long-term credit rating still reflects the issuer, while the short-term rating reflects the bank. In practice this means an SBPA offers strong short-term protection but leaves long-term issuer credit exposure with the investor.
Draw-Stop Events
The bank’s promise is not absolute. Both LOCs and SBPAs contain narrow exceptions known as draw-stop events, in which the bank is released from its obligation to buy tendered bonds.1Municipal Securities Rulemaking Board. About Municipal Variable Rate Securities These include the issuer’s bankruptcy or insolvency, a downgrade of the issuer below investment grade, a payment default, or a determination that the bonds are taxable when they were issued as tax-exempt. Outside those extreme scenarios, the bank must pay.
What Happens After a Failed Remarketing
Once the bank purchases tendered bonds, those securities leave the public market and are reclassified as “bank bonds.” The terms change. The floating tax-exempt rate is replaced by a bank-held rate, typically defined as a percentage of the bank’s prime rate or SOFR plus a specified margin. This rate is substantially higher than the public variable rate and is generally structured as a taxable obligation to the bank, even when the underlying bonds were originally tax-exempt.
The issuer now owes the bank directly, on an accelerated repayment schedule dictated by the SBPA. The issuer resolves this by successfully remarketing the bonds back to public investors once conditions improve, by issuing replacement debt, or by paying from reserves. The bank bond conversion is designed to be temporary, but the higher interest cost and compressed repayment timeline create real financial pressure on the issuer.
Facility Expiration
The LOC or SBPA has its own expiration date, usually far shorter than the bond’s final maturity. A 30-year demand bond might have a liquidity facility that expires in three to five years. Before that expiration, the issuer must renew with the same bank, secure a replacement facility from a different bank, or convert the bonds out of variable-rate mode.
If the issuer cannot line up a replacement facility, the bonds typically face a mandatory tender, meaning all outstanding holders must surrender their bonds. The issuer then needs cash to pay everyone off or must convert the bonds to a fixed-rate or term-rate mode where the put option no longer applies.3S&P Global. Credit FAQ: Navigating a Rise in Variable-Rate Demand Bonds Across US Public Finance Sectors Conversion to fixed rate eliminates the liquidity facility cost but also eliminates the put option and the short-term rate advantage that made the demand bond attractive in the first place.
Who Buys Demand Bonds
Demand bonds are typically sold in minimum denominations of $100,000, putting them squarely in institutional territory.4Municipal Securities Rulemaking Board. Interest Payments Money market funds are the dominant buyers. High-net-worth individuals and corporate treasury departments also participate.
Money market funds are the natural home. Under SEC Rule 2a-7, a long-term variable rate security with a demand feature is treated as having a maturity equal to the longer of the period until the next rate reset or the period until the holder can recover principal through the put option.5eCFR. 17 CFR 270.2a-7 – Money Market Funds A weekly-reset demand bond with a weekly put counts as a seven-day maturity for regulatory purposes, even though the bond itself matures in 2050. That treatment lets money market funds hold demand bonds while maintaining a stable net asset value.
For an individual investor, the fit is harder. The $100,000 minimum is a barrier, and the floating rate means the income stream changes constantly. Still, for a high-bracket taxpayer looking for a liquid, tax-advantaged place to park cash, a demand bond can serve that role. The advantage over a long-term municipal bond is that you carry no interest rate risk on the security itself. If rates rise, the coupon adjusts upward rather than the bond’s price falling.
Tax Treatment
Most demand bonds are issued by state and local governments, and the interest is excluded from federal gross income under Section 103 of the Internal Revenue Code.6Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds The tax exemption is why demand bond yields can sit well below comparable taxable money market rates while still delivering competitive after-tax returns.
The exemption does not apply universally. Private activity bonds that are not “qualified bonds” under the tax code, arbitrage bonds, and bonds not issued in registered form all lose the exclusion.6Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds Check the official statement before assuming interest is tax-free.
Holding a demand bond issued within your state of residence may also exempt the interest from state and local income tax, producing a triple-tax-exempt yield. The exemption applies only to interest, not to the return of principal when the bond is tendered.
Risks Investors Should Weigh
The biggest misconception about demand bonds is that they are risk-free because they trade at par. They are low-risk in practice, but the risk is not zero, and it concentrates in places that are not obvious.
- Liquidity provider downgrade. The put option is only as good as the bank behind it. If the bank’s short-term rating drops, the bonds it supports may become ineligible for money market funds. The resulting wave of tenders can trigger a failed remarketing, and if the downgrade is severe enough to constitute a draw-stop event, the bank may not be obligated to purchase at all.
- Draw-stop events. Under extreme circumstances, the bank can refuse to honor the put. Triggers include the issuer’s bankruptcy, a downgrade of the issuer below investment grade, a payment default, or a determination that the bond’s interest is taxable. If a draw-stop is triggered, the holder is left with a long-term bond at whatever rate the market will bear.
- Rate-setting failure. If the remarketing agent sets a rate too low to clear the market, the remarketing fails. In isolation this is not catastrophic because the bank steps in. Repeated failures, though, signal deeper problems with the credit or the market, and the issuer’s borrowing costs escalate as bonds convert to the higher bank-bond rate.
- Facility expiration. When the liquidity facility expires without a replacement, holders face a mandatory tender. This is usually an orderly process, but if the issuer cannot pay, investors may not receive par value on the timeline they expect.
The essential task for a demand bond investor is separating short-term from long-term credit risk. Short-term risk on any given tender is mitigated by the bank’s LOC or SBPA. Long-term risk belongs to the municipality and matters only if the put option disappears, through a draw-stop event, a failed facility renewal, or a conversion to fixed rate. In those scenarios, the holder is left with a long-term bond whose value depends on the municipality’s fiscal health and prevailing interest rates, which is exactly the risk the demand structure was meant to avoid.