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.

Do you do much bank borrowing?

Very little. We can typically borrow cheaper from the public market than we can borrow from banks.

What function do the ratchet bonds serve in the TVA’s debt portfolio?

They provide optionality to us at a very reasonable price. Buying optionality in the market for the last 10 or 12 years has been pretty expensive. By optionality I mean the right to call bonds for early redemption prior to their maturity date or to lower interest expense. The ratchet bond really doesn’t have a call option associated with it. But it’s effectively a call option, because if interest rates go down, it’s just the same as if the bonds had been called.

We’ve issued two ratchet bonds. The first ones were originally issued at a rate of 6.75 percent, have reset downward three times, and are currently at 5.46 percent. The second started with a coupon of 6.5 percent and they’ve ratcheted down twice, to 5.17 percent currently. The reset can only happen once a year.

The spread’s determined in advance, which is a big advantage right now. Rates are historically low but spreads are also pretty much historically wide right now. So the fact that the ratchet bonds have a preset spread is a huge advantage in this market. And we’ve paid no transaction cost for call premiums on the old debt or transaction costs or underwriter’s fees on any new debts.

We’ve been pleased to have the ratchet bonds in our portfolio. They’ve done exactly what we thought they would do. The interest rates have reset several times. They also provide an automatic process of determining when to pull the trigger to lower the rates. Anytime that you’re managing debt and you see an opportunity to call bonds, you’re always faced with the problem: Should I do it now? Should I wait and see if rates get a little lower?

There are always people with 20-20 hindsight that say, “Well, you know that if you’d have called the bonds two months later you might have saved 20 basis points on the refinancing.” And the ratchet bonds take that part of the second-guessing out of the refinancing process.  It’s very seldom that you pull the trigger on a call that’s the exact low point in the markets. There’s always room to second-guess a call decision.

What does the remaining 95 percent of your debt portfolio look like?

The majority is non-callable. We look at the cost of optionality every time we issue debt. If the cost of optionality exceeds the present value of what we thought we could save from refinancing the debt at the call date we would not elect to pay for that call premium.

In this low-interest-rate environment we’ve been in for the last decade, we were, for example, in a situation in which we issued 40-year bonds at 4.86 percent and elected not to pursue a call option. That’s because the cost of the call option would have put the rate up over 6 percent and we would have to call it at a rate at something below the 4.86 percent to get the price of the call premium back. We’ve just not been able to justify paying the cost of the call premium because of the question about whether we’d be able to recoup that cost in the refinancing.








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