The Power of the Callable Bond

Finding the option to refinance debt too costly, the treasurer of the Tennessee Valley Authority unearths a way to ratchet down the premiums.

Nearly 76 years after it was formed, the Tennessee Valley Authority still looks good during periods of economic catastrophe. Set up in 1933 by Congress in the teeth of the Depression to restore the over-farmed, water-damaged Tennessee Valley and to build dams to generate electricity, the TVA’s bonds today seem as alluring to investors as they did during the New Deal.

Part of the attraction, of course, is that its debt is a line item of the balance sheet of the U.S. government. To be sure, while the TVA is a government-owned company, its securities aren’t backed by the full faith and credit of the United States. Still, investors are likely to remember that the lack of overt backing didn’t deter the government from taking over Fannie Mae and Freddie Mac last fall and backing up their debt.

Taxpayers, too, might find the TVA model enticing in these days of trillion-dollar stimulus packages. Originally funded mainly by Congressional appropriations, since 1999 the company has been financing itself exclusively through its own power-generation revenues and debt issuance. In 2008, the TVA took in $10.3 billion in revenues and had $22.7 billion of bonds outstanding (it has a statutory limit of $30 billion).

With a reliable flow of revenue, implicit backing of the U.S. government, and a fairly cheap cost of capital, you’d think John Hoskins, the utility’s treasurer, would have had less to worry about than most of his peers in the corporate sector when the credit crunch hit in the fall of 2008. Indeed, by September and October, the company had taken advantage of low coupon-rates earlier in the year and was holding record-low levels of short-term debt.

Still, the electrical wholesaler lives and dies by its customers, and there were days when Hoskins worried that the nation’s credit would come to a halt. “If the credit markets froze up, you’d see companies that rely on short-term funding default on their obligations and likely go into bankruptcy,” he told CFO.com during an interview on Jan. 30. “We’re in the electric utility business, we sell directly to a lot of major companies in the Southeast, and we’d like to see those companies remain healthy financially viable companies.”

A more routine concern of Hoskins’s is keeping the cost of his debt low. As such, he’s intensely focused on the price of what he calls “optionality”: the ability to call in and refinance TVA bonds. Although he’d like to retain the ability to make such moves as often as possible, the treasurer has found that what he might gain through refinancing hasn’t been enough to justify the cost of making the bonds callable.

Still, in the case of about 5 percent of the utility’s debt portfolio, Hoskins has found a solution to the dilemma. With the help of consultant Andrew Kalotay, who’s promoting the arrangement, the TVA has constructed two debt offerings of “putable automatic rate reset securities,” also known as “ratchet bonds.”  After a fixed-rate period of five years, the coupon rate on the bonds may be automatically reset – or “ratcheted” – downward under certain market conditions each year.

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