RATCHET BONDS: MAXIMUM REFUNDING EFFICIENCY AT MINIMUM TRANSACTION COST

Abstract

Callable bonds, which are widely used by corporate borrowers to manage interest rate risk, have several major drawbacks. Foremost is the transaction cost of refunding. In addition, poor execution—calling too early or too late—is common, causing a transfer of wealth from shareholders to bondholders. The Ratchet bond captures the advantages of a callable bond—the ability to lower interest costs when rates decline—while eliminating its undesirable features. If rates fall after issuance, the coupon of a Ratchet bond automatically resets to the yield of a specified Treasury bond plus some fixed spread. The resulting “step‐down” cash flow pattern resembles that of a sequence of callable bonds that are refunded to the same original maturity date. The Tennessee Valley Authority was the first to use this innovative structure. In June 1998, they sold $575 million 6.75%“PARRS” with a 30‐year maturity and annual rate resets beginning after five years. Moreover, as this article went to print, TVA announced its intent to sell another large Ratchet issue with features virtually identical to the PARRS described in this article.