Innovative Bond Structure Sidesteps Credit Crisis

13 January 2009

An unintended consequence of the Freddie and Fannie bailout is that other, better-run agencies not under the Treasury umbrella are having trouble refunding callable debt. However, at least one issuer — the Tennessee Valley Authority (TVA) — mitigated this problem with an innovative “Ratchet Bond,” which allows it to benefit from lower interest rates without refunding. The idea was brought to TVA by their advisors, Andrew Kalotay Associates, Inc. (

A Ratchet Bond is like a conventional floating rate bond, but its coupon can be reset only downward. TVA issued two of these structures with 30-year maturities, totaling over $1 billion in size. Over the last six years, the coupon on the first issue has declined from 6.75% to 5.46%; the second from 6.50% to 5.17%. Because of the Ratchet Bonds automatic reset feature, TVA reduced its interest expense without incurring the customary fees associated with tapping into the capital markets.

“Ratchet Bonds can be a debt manager’s lifeline in stormy markets,” says Dr. Andrew Kalotay, president of Andrew Kalotay Associates, who helped TVA with the first Ratchet Bond issue in 1998. “By relying exclusively on callable bonds, federal agencies, corporations, and municipalities are missing out on the benefit of today’s record-low Treasury yields.”

Dr. Kalotay also points out the considerable expense borne by issuers from recurrent calling and refunding cycles. For example, in the second half of December alone, Freddie Mac called more than 700 issues totaling $29 billion. The associated reissuance cost, even by conservative estimates, exceeds $50 million.

“Ratchet Bonds are superior to callable bonds in two significant ways,” he says. “Their coupons decline in tandem with Treasury yields (or benchmark rates) regardless of the credit environment. In addition, Ratchet Bonds eliminate the ongoing reissuance expense associated with refunding callable bonds.”

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