Once a standard for long-term corporate bonds, the call feature seems to have fallen out of favor. Among electric utilities, where debt is a dominant part of the capital structure, virtually every 30-year bond used to be callable after five or 10 years. These structures gave issuers the advantage of being able to reduce interest expense if rates declined, by calling the bonds and refunding them at lower coupons.
Over the last 20 years, competition among bond underwriters for deal volume led them to promote plain vanilla, optionless bonds instead of callable bonds, on the grounds that they are easier to sell — investors are assured of a fixed rate for the life of the bond. Issuers went along without complaint. But the long-term consequence of abandoning callable bonds has been expensive: today the average price of electric utility bonds is around 120 percent of par, because they are paying much higher than prevailing interest rates. Consumers in turn are penalized, as regulators have allowed utilities to pass on the higher financing costs.
Among investor-owned utilities, a couple of notable exceptions who continue to issue callable bonds from time to time are Alabama Power and Georgia Power. The call options in their debt portfolios shorten duration, making them less sensitive to declining interest rates. Consequently the prices of these issuers’ bonds are well below the industry average.
Within the electric sector, there is another group whose bonds aren’t at a high premium. These are the lower-rated companies who can’t issue long-maturity ( i.e., 30-year) bonds due to a lack of investor appetite. Thus falling interest rates haven’t hurt them as much as their higher-grade peers. PNM Resources, where the longest bond outstanding is less than 10 years, is one such example.
One issuer has taken another approach: ratchet bonds. This innovative structure goes one better than callable bonds when it comes to taking advantage of lower interest rates. Ratchet bonds save money when rates fall, while holding coupons constant when rates rise. Savings happen automatically, with no transaction costs, which makes ratchet bonds an attractive alternative.
The Tennessee Valley Authority issued two ratchet bonds in the late 1990s. The considerable interest savings generated by these bonds before, during, and after the financial crisis, contributed to lower electricity rates for TVA’s customers. How do the TVA ratchet bonds work? Their coupons reset annually to the 30-year CMT, or constant maturity treasury rate, plus a fixed spread, but only if the resulting coupon is lower than the current coupon. There’s no reset if the resulting coupon is higher.
The TVA Experience
TVA followed up in 1999 with