Floating Rate Notes (FRNs), Variable Rate Demand Obligations (VRDOs, VRDBs), and Auction Rate Securities
Floating Rate Notes (FRNs), Variable Rate Demand Obligations (VRDOs/VRDBs), and Auction Rate Securities (ARS)
Floating rate notes, variable rate demand obligations and bonds, and auction rate securities are structurally related but fundamentally distinct instruments designed to manage interest rate exposure, liquidity transformation, and short-duration credit risk through periodic rate resets tied either to external benchmarks, intermediary-driven remarketing processes, or market-clearing auctions. While FRNs reset coupons mechanically off reference rates such as SOFR, VRDOs rely on remarketing agents and bank liquidity facilities to maintain par pricing with embedded investor puts, and ARS depend on periodic auctions — historically supported by broker-dealers — to determine clearing rates and provide de facto liquidity. Taken together, these instruments represent different approaches to engineering short-duration characteristics out of longer-dated liabilities, redistributing interest rate risk, liquidity risk, and counterparty dependence across issuers, investors, dealers, and banks. This chapter examines their structural mechanics, historical development, trading behavior and spread regimes, investor base and regulatory treatment, and the systemic dislocations observed during the 2007-2009 period — particularly the early 2008 breakdown in auction markets and remarketing processes — which permanently reshaped how liquidity is priced and provided in short-duration credit markets.
https://www.bis.org/publ/qtrpdf/r_qt1903e.pdf
https://www.imf.org/en/publications/gfsr
https://www.federalreserve.gov/supervisionreg/srletters/SR2027.htm
Within the broader architecture of global funding markets, these instruments sit between traditional money market products and longer-duration credit, often functioning as substitutes for commercial paper, repo, and Treasury bills while embedding varying degrees of credit and structural complexity. Corvid Partners views FRNs, VRDOs, and legacy ARS as a spectrum of engineered liquidity instruments, where the apparent stability of principal and short reset periods masks materially different underlying dependencies — ranging from transparent benchmark-linked cash flows to opaque reliance on dealer balance sheets or bank liquidity facilities. The firm's principals were active participants in the ARS market during its 2008 collapse — not as observers, but as buyers of failed auction paper at a time when most of the market was frozen and most institutional participants were focused on containment rather than opportunity. When major broker-dealers withdrew their support bids in February 2008 and auction failure rates surged above 80 percent, failed ARS were paying penalty rates in some cases well north of 20 percent — rates that bore no relationship to the underlying credit quality of the obligations, which in many cases remained fully sound. Corvid's principals sourced and accumulated failed paper during this period, holding it while it paid those elevated penalty rates, and in certain cases offered direct refinancing solutions to issuers who could no longer access the ARS market and needed an alternative path to restructuring their obligations. That experience — understanding which credits were genuinely impaired versus which were simply trapped in a structurally broken market, pricing the difference between contractual and non-contractual liquidity under real stress, and providing capital at a moment when it was scarce — is the foundation from which the firm evaluates floating-rate and liquidity-enhanced instruments today. It also includes experience analyzing failed auctions, bank bonds created through VRDO liquidity draws, and the repricing of floating-rate credit as bank balance sheet constraints and regulatory capital requirements began to bind post-crisis.
https://www.sifma.org/resources/guides-playbooks/about-the-municipal-swap-index
https://www.bis.org/publ/qtrpdf/r_qt1903e.pdf
What These Instruments Are and How They Actually Work
At the desk level, the first and most important distinction to make among FRNs, VRDOs, and ARS is not about coupon mechanics — it is about where liquidity actually comes from and what happens to it under stress. That question determines how these instruments should be sized, priced, hedged, and held in a portfolio, and it is the question that most investors in this space consistently underweighted before 2008.
Floating rate notes are the simplest and most structurally robust of the three. The coupon resets periodically — typically quarterly — off an observable benchmark plus a fixed spread. The benchmark is external, transparent, and not dependent on any market participant's behavior or balance sheet commitment. Prior to the transition away from LIBOR, most FRNs referenced interbank offered rates; since June 30, 2023, when all remaining USD LIBOR panel settings ceased, the market has migrated to the Secured Overnight Financing Rate published daily by the Federal Reserve Bank of New York. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repo market, with approximately $1 trillion in underlying daily transactions — a far deeper and more manipulation-resistant foundation than the bank-survey-based LIBOR it replaced.
The economic effect of periodic resetting is a near-elimination of duration risk: price sensitivity is largely confined to the period between resets, and FRNs typically trade very close to par unless driven by credit spread movements rather than rate shifts. The U.S. Treasury has issued two-year FRNs since January 2014, with the coupon tied to the weekly 13-week Treasury bill auction rate plus a fixed spread — over the period from 2014 to 2023, excess spreads at Treasury FRN auctions have ranged from approximately 5 to 39 basis points above no-arbitrage values, reflecting investor demand for the instrument's duration-hedging characteristics. Government-sponsored enterprises including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks are also major FRN issuers, providing an agency tier in the floating rate credit spectrum between sovereign paper and corporate issuers.
https://www.newyorkfed.org/arrc/sofr-transition
https://treasurydirect.gov/marketable-securities/floating-rate-notes/
https://www.nber.org/system/files/working_papers/w27065/w27065.pdf
https://en.wikipedia.org/wiki/Floating_rate_note
VRDOs introduce a more complex structure, combining long-term municipal credit exposure with short-term liquidity features through embedded put options and third-party liquidity support. The remarketing agent — typically a major bank or broker-dealer — resets the coupon daily or weekly to a level that allows the bonds to clear at par in the secondary market. If the agent cannot place the bonds, a liquidity provider, usually a bank under a standby bond purchase agreement or letter of credit, is contractually obligated to purchase them. This creates a structural reliance on both the remarketing function and the creditworthiness and balance sheet capacity of the liquidity provider — effectively transferring liquidity risk from investors to banks under normal conditions. The primary liquidity providers in the VRDO market — JPMorgan, Bank of America, Wells Fargo, U.S. Bank, and Citigroup — have historically written the large majority of standby bond purchase agreements and letters of credit, with just four banks writing approximately 60 percent of letters of credit sold to municipalities in the post-crisis period.
https://www.bondbuyer.com/news/floating-rate-debt-faces-a-liquidity-issue
Auction rate securities, by contrast, relied on periodic auctions to set rates and provide liquidity, without explicit backstop facilities. Investors submitted bids specifying the minimum acceptable rate, and the clearing rate was set at the lowest level sufficient to place the entire issue. Ronald Gallatin at Lehman Brothers invented the instrument in 1984, and Goldman Sachs executed the first tax-exempt ARS in 1988 — a $121.4 million financing for Tucson Electric by the Industrial Development Authority of Pima County, Arizona. In normal conditions, auctions cleared consistently at seven, twenty-eight, or thirty-five day intervals, and the securities traded as de facto short-term instruments despite long maturities. Broker-dealers — principally Citigroup, UBS, Morgan Stanley, and Merrill Lynch — played a critical but entirely unofficial role by submitting support bids to prevent auction failures, creating the appearance of continuous liquidity without any contractual obligation to do so.
https://en.wikipedia.org/wiki/Auction_rate_security
The LIBOR-to-SOFR Transition — What It Actually Meant for FRN Markets
The transition away from LIBOR is the most consequential structural change in the FRN market in decades, and understanding its mechanics is essential for evaluating legacy positions and new issuance alike. LIBOR was a bank-survey-based rate that embedded a term bank credit premium — the spread between unsecured interbank lending rates and risk-free rates. SOFR is a secured overnight rate with no bank credit premium. The two rates are not economically equivalent, which created the central challenge of the transition: how to convert trillions of dollars of legacy LIBOR contracts to SOFR without inadvertently repricing the embedded credit component.
The Alternative Reference Rates Committee — convened by the Federal Reserve and the New York Fed, with the ARRC formally selecting SOFR as the replacement for USD LIBOR in 2017 — developed the solution in the form of hardwired fallback language and fixed credit spread adjustments. The spread adjustments were calculated as the five-year historical median difference between each USD LIBOR tenor and compounded SOFR over the period from March 2016 to March 2021, fixed permanently on March 5, 2021 when the FCA announced future cessation dates for LIBOR settings. The resulting adjustments are 11.448 basis points for one-month LIBOR, 26.161 basis points for three-month LIBOR, and 42.826 basis points for six-month LIBOR — meaning a legacy three-month LIBOR FRN paying LIBOR plus 50 basis points converts to Term SOFR plus 76.161 basis points on a like-for-like economic basis.
https://www.newyorkfed.org/arrc/sofr-transition
https://www.newyorkfed.org/arrc/publications/fallbacks
The market coalesced around Term SOFR — forward-looking term rates published by CME Group in one-month, three-month, and six-month tenors, endorsed by the ARRC in July 2021 — as the practical replacement for LIBOR in syndicated loans and most FRN cash products, because Term SOFR has the same operational characteristics as LIBOR: it is a forward-looking rate known at the beginning of the interest period, allowing borrowers and issuers to know their interest obligations in advance. Daily compounded SOFR in arrears — the rate ISDA implemented as the primary derivatives fallback — requires knowing the rate at the end of the calculation period, creating operational complexity for cash products and a potential basis between hedged loans and their associated swaps. Understanding which SOFR convention applies to a given FRN or loan — Term SOFR, daily simple SOFR, daily compounded SOFR in arrears, or compounded SOFR in advance — remains a live analytical issue for any portfolio containing both legacy and new-issue floating rate instruments.
The February 2008 ARS Market Collapse — What Actually Happened and Who Did It
The collapse of the auction rate securities market in February 2008 is not merely a historical case study in liquidity risk — it is the single most instructive episode in the history of engineered short-duration instruments, and understanding it in detail is prerequisite to understanding why VRDOs and FRNs are priced and traded the way they are today.
From 1984 through the end of 2007, there were a total of 44 failed ARS auctions across the entire market. On February 13, 2008, 80 percent of auctions failed. On February 20, 62 percent failed — 395 out of 641 auctions. The speed and totality of the collapse was not accidental. It was the direct consequence of the four largest broker-dealers in the ARS market — Citigroup, UBS, Morgan Stanley, and Merrill Lynch — simultaneously withdrawing the support bids they had been submitting for years to prevent auction failures. These bids were never contractually required. They were an informal market maintenance practice, and when the firms' balance sheets came under stress from broader structured credit losses in late 2007 and early 2008, the practice ended almost simultaneously across the major dealers.
https://en.wikipedia.org/wiki/Auction_rate_security
https://www.sec.gov/enforcement-litigation/litigation-releases/lr-20824
The regulatory and legal response was swift and unprecedented in scale. The SEC and the New York Attorney General under Andrew Cuomo pursued enforcement actions against the major dealers for having marketed ARS to investors as safe, cash-equivalent instruments while knowing that the market's apparent liquidity depended entirely on their voluntary support bids — bids they were in the process of withdrawing. Citigroup settled SEC charges in August 2008, agreeing to buy back approximately $7.3 billion in ARS sold to retail investors, charities, and small businesses, plus best-efforts liquidity solutions for the approximately $12 billion in ARS it had sold to institutional investors. UBS settled simultaneously, agreeing to purchase approximately $22.7 billion in ARS from affected customers. Together the Citigroup and UBS settlements alone provided nearly $30 billion in liquidity. Merrill Lynch agreed to buy back up to $7 billion from retail investors effective January 2009. The Cuomo settlements with eight firms — Citigroup, UBS, JPMorgan, Morgan Stanley, Wachovia, Merrill Lynch, Goldman Sachs, and Deutsche Bank — provided relief to approximately 183,000 investors holding close to $50 billion in illiquid ARS. Across all the SEC's ARS settlements, including Citigroup, UBS, RBC, Deutsche Bank, Wachovia, and Bank of America, more than $67 billion was ultimately returned to ARS customers of the settling firms.
https://www.sec.gov/news/press/2008/2008-290.htm
https://www.sec.gov/enforcement-litigation/litigation-releases/lr-20824
https://www.sec.gov/enforcement-litigation/litigation-releases/lr-21780
https://www.govinfo.gov/content/pkg/CHRG-110hhrg45624/html/CHRG-110hhrg45624.htm
The SEC's complaints described in detail how Citigroup and UBS, as the market deteriorated in late 2007 and early 2008, had been forced to purchase increasing amounts of ARS inventory to prevent auction failures — using their own balance sheets to prop up markets while simultaneously reducing their customers' awareness of the mounting liquidity risk. The firms then chose to stop supporting auctions, effectively offloading the liquidity risk onto the customers to whom they had been selling the instruments as cash equivalents. UBS took writedowns valuing some ARS portfolios at discounts of more than 20 percent from par following the market freeze.
https://www.sec.gov/enforcement-litigation/litigation-releases/lr-20824
The Dealer and Bank Position — Where Risk Actually Sits
At the desk level, the defining feature across FRNs, VRDOs, and legacy ARS is not the reset mechanism but where risk actually resides when the system is functioning normally versus when it is stressed. In benign environments, these instruments appear to distribute risk efficiently — FRNs pass rate risk to investors, VRDOs pass liquidity risk to banks, and ARS historically passed both to the market. In reality, during periods of stress, risk concentrates rapidly on dealer balance sheets and bank liquidity providers, and understanding that migration is central to how these instruments trade.
In the FRN market, dealer warehousing risk is relatively straightforward. Inventories are managed against funding curves, and positioning is typically hedged via interest rate swaps or short-duration credit indices. The real risk for dealers in FRNs is not duration but spread widening tied to funding stress, particularly in financial issuers, where spreads can gap out in tandem with CDS and unsecured funding costs. Dealer balance sheet usage in FRNs is efficient and capital-light relative to other credit products, reinforcing their role as a core liquidity instrument.
VRDOs are fundamentally different because dealers do not warehouse the core risk — the banks do. The reason banks provide standby bond purchase agreements and letters of credit is rooted in fee economics and client relationships: pre-crisis, these facilities generated steady fee income with minimal expected utilization, as remarketing failures were historically rare. Regulatory capital treatment was also favorable, allowing banks to treat these exposures as contingent rather than funded. This created a structural incentive to underprice liquidity risk, particularly in a low-volatility environment where historical failure rates were negligible. Under Basel III, this economics shifted substantially — the capital and liquidity requirements for providing municipal VRDO facilities effectively require more than $2 in bank balance sheet for every $1 of credit facility provided, incorporating both the capital charge and the liquidity coverage ratio requirement to maintain liquid assets sufficient to honor the facility in a stress scenario.
https://saberpartners.com/press/the-bond-buyer-5/
https://www.bondbuyer.com/news/floating-rate-debt-faces-a-liquidity-issue
When remarketing fails, the transition from contingent exposure to funded asset is immediate. The VRDO is purchased by the bank at par and becomes a balance sheet asset subject to capital charges, liquidity coverage requirements, and internal funding costs. These positions — bank bonds in the market's terminology — are typically priced at a spread reflecting both the underlying municipal credit and the bank's cost of funds plus a penalty margin defined in the liquidity agreement. In stressed environments, penalty rates can be several hundred basis points above normal VRDO reset levels. The true economic cost to the bank incorporating capital charges and liquidity buffers is typically higher still, leading banks to actively seek to offload these positions into the secondary market, often at discounts that reflect the forced selling context.
The secondary trading of failed VRDOs is highly idiosyncratic and far less liquid than the primary remarketing market. These securities are no longer treated as cash-equivalent instruments but as distressed or semi-distressed municipal credit with embedded structural complexity. Buyers are typically crossover investors — hedge funds, opportunistic credit funds, and certain insurance accounts — who are willing to underwrite both the credit and the structural risk at a discount to par. Discounts of several points are not uncommon in stressed conditions, and in severe dislocations, double-digit discounts have been observed when bank counterparties themselves are under pressure. Pricing in this secondary market is driven less by traditional municipal spread curves and more by yield-to-worst analysis, expected time to successful remarketing, and the credibility of the liquidity provider.
https://www.sec.gov/resources-for-investors/investor-alerts-bulletins/investorarshtm
https://www.msrb.org/Variable-Rate-Securities
The 2008 feedback loop in the VRDO market illustrated how quickly these dynamics compound. As short-term investors pulled back and remarketing agents struggled to place bonds, liquidity facilities were increasingly drawn. As bank credit spreads widened and counterparty risk became more acute, VRDO reset rates became more volatile and less predictable. As reset rates rose, money market fund demand declined further. The cycle fed on itself until the banking system's collective ability and willingness to absorb bank bonds constrained the entire market's functioning.
https://www.bis.org/publ/qtrpdf/r_qt1903e.pdf
https://www.imf.org/en/publications/gfsr
Trading Dynamics and the Spread Spectrum
FRNs trade as liquid spread products closely tied to funding markets, with tight bid-ask spreads and active dealer participation. Pricing is driven by spread over the reference curve rather than yield, and relative value is assessed against other floating-rate instruments, short corporates, and funding markets.
At the desk level, the FRN spread spectrum in the US dollar market is tiered clearly by issuer type. US Treasury FRNs — two-year instruments indexed to the 13-week T-bill auction rate — trade at or very close to zero spread over the index, with the excess spreads documented at auction reflecting investors' demand for duration-hedging convenience rather than any credit premium. Agency FRNs from Fannie Mae, Freddie Mac, and the Federal Home Loan Banks trade in the range of approximately 5 to 25 basis points over SOFR, reflecting the implicit government support and deep liquidity of the agency market. Senior unsecured FRNs from large financial institutions — JPMorgan, Goldman Sachs, Bank of America — have historically traded in the range of approximately 20 to 80 basis points over SOFR depending on tenor and market conditions, with spreads compressing during periods of abundant liquidity and widening sharply when bank funding costs rise. Investment-grade corporate FRNs typically range from approximately 75 to 200 basis points over SOFR, with significant sector variation — utility and infrastructure issuers at the tighter end, cyclical industries and lower-rated issuers at the wider end. Below-investment-grade and subordinated financial FRNs extend well beyond 200 basis points, with high-yield corporate FRNs and bank capital instruments trading in the 200 to 500 basis point range depending on credit quality and market conditions.
https://treasurydirect.gov/marketable-securities/floating-rate-notes/
https://en.wikipedia.org/wiki/Floating_rate_note
The important dynamic in FRN spread behavior is the compression and widening cycle tied to bank funding conditions. During periods of abundant liquidity — the extended post-crisis period of zero interest rates and quantitative easing from 2009 through 2021 — financial institution FRN spreads compressed materially, sometimes approaching the tight end of their historical ranges. As the Federal Reserve began tightening in 2022, funding costs rose and financial FRN spreads widened, though the transmission was faster in the unsecured overnight and short-term bank funding markets than in the FRN market, creating relative value opportunities between the two.
VRDO rates function differently — they are not pure market-clearing rates but are influenced by remarketing agent behavior, investor demand primarily from tax-exempt money market funds, and the economics of the liquidity facility. Pre-2008, VRDOs often priced at very low nominal yields — frequently inside comparable taxable instruments on a tax-adjusted basis — because liquidity facilities were inexpensive and widely available. In the post-crisis environment, with Basel III increasing the cost of providing liquidity facilities and many banks having exited the business following the crisis, VRDO reset rates became more volatile and the market shrunk substantially from its pre-2008 peak. The market now differentiates actively between VRDOs with strong, well-capitalized liquidity providers — JPMorgan, Wells Fargo, Bank of America, U.S. Bank — and those with weaker structures or counterparties. The former trade close to par with low reset volatility; the latter may require yield concessions or trade intermittently. The spread between these cohorts can widen meaningfully during periods of bank stress.
https://www.bondbuyer.com/news/floating-rate-notes-tell-a-tale
https://saberpartners.com/press/the-bond-buyer-5/
Post-Crisis Structure — What Changed and What Didn't
In the aftermath of the 2008 crisis, the ARS market effectively ceased to function. Most outstanding securities were either restructured, redeemed at par following the settlements, or converted into other forms. VRDO markets survived but at reduced scale, with significantly higher costs for liquidity facilities and greater scrutiny of bank counterparties. The experience reinforced the importance of explicit, contractual liquidity mechanisms and highlighted the risks of relying on dealer behavior or market convention as substitutes for structural support.
FRNs gained prominence as a simpler and more transparent alternative. The subsequent LIBOR-to-SOFR transition, completed with the cessation of all USD LIBOR panel settings on June 30, 2023, further strengthened the market by removing the bank-survey-based rate-setting mechanism that had enabled the LIBOR manipulation scandal of 2012 and replacing it with a transaction-based overnight secured rate with vastly deeper underlying markets.
https://www.newyorkfed.org/arrc/sofr-transition
https://www.sec.gov/resources-for-investors/investor-alerts-bulletins/investorarshtm
From a modern portfolio construction standpoint, these instruments sit on a clearly defined spectrum. At one end, FRNs represent a benchmark-driven, scalable, and highly liquid expression of floating-rate credit, closely integrated with funding markets and derivative hedging frameworks. In the middle, VRDOs offer structurally supported liquidity through bank backstops but embed a second layer of credit exposure tied to the strength, pricing, and regulatory posture of liquidity providers. At the far end, ARS — largely relegated to legacy status — serve as a permanent case study in the risks of relying on non-contractual liquidity and the speed with which confidence-driven markets can reprice when that assumption is challenged. The distance between a resilient instrument and a failed one is not simply whether the rate floats — it is whether liquidity is supported by transparent, enforceable structures or by assumptions about market behavior that may not hold in adverse conditions.
https://www.bis.org/publ/qtrpdf/r_qt1903e.pdf
https://www.imf.org/en/publications/gfsr
https://www.federalreserve.gov
Corvid Partners approaches floating-rate and liquidity-enhanced instruments not as homogeneous short-duration assets but as differentiated exposures defined by where risk ultimately resides and how it is transferred under stress. The firm's principals were present at the defining moment in the history of this asset class — buying failed ARS paper in February and March 2008 when penalty rates on structurally sound credits had moved well above 20 percent, holding those positions while the penalty rate clock ran, and in certain cases structuring direct refinancing alternatives for issuers who could not wait for the ARS market to reopen. The gap between where that paper was trading — effectively zero bid in a frozen market — and what it was actually worth to a holder with the credit knowledge and balance sheet to own it through resolution was among the cleanest expressions of liquidity premium over credit risk that fixed income markets have produced in the modern era. That experience, combined with the firm's broader engagement across the LIBOR-to-SOFR transition, VRDO bank bond dynamics, and the evolution of short-duration funding markets post-crisis, grounds its analytical framework in what actually happened when engineered liquidity failed — and in the specific, executable judgment about which obligations were worth owning when almost no one else would.
https://www.bis.org/publ/qtrpdf/r_qt1903e.pdf
https://www.imf.org/en/publications/gfsr
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https://www.bis.org/publ/qtrpdf/r_qt1903e.pdf
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https://www.newyorkfed.org/arrc/sofr-transition
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https://www.nber.org/system/files/working_papers/w27065/w27065.pdf
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https://en.wikipedia.org/wiki/Floating_rate_note
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https://en.wikipedia.org/wiki/Auction_rate_security
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https://www.sec.gov/news/press/2008/2008-290.htm
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https://www.sec.gov/enforcement-litigation/litigation-releases/lr-20824
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https://www.sec.gov/news/press/2008/2008-181.htm
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https://www.sec.gov/enforcement-litigation/litigation-releases/lr-21780
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https://www.govinfo.gov/content/pkg/CHRG-110hhrg45624/html/CHRG-110hhrg45624.htm
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https://www.bondbuyer.com/news/floating-rate-notes-tell-a-tale
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https://www.bondbuyer.com/news/floating-rate-debt-faces-a-liquidity-issue
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https://saberpartners.com/press/the-bond-buyer-5/
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https://www.sifma.org/resources/guides-playbooks/about-the-municipal-swap-index
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