Cash Management

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.
David KatzFebruary 9, 2009

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 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.

While the company pays a price for the automatic-reset feature, Hoskins says that it’s much cheaper than making frequent calls on bonds. Perhaps equally important though, is that it enables him to avoid the headache of making bets on when interest rates have reached their low. “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,” he explains. An edited version of the conversation, which ranged beyond bonds to the treasury function in general, follows.

As treasurer of TVA, what’s your biggest worry?

I think anytime we see the situation we saw last fall, when the credit markets were close to being frozen — I think that’s one of my biggest concerns. Most businesses that operate as going concerns assume that there are going to be functional credit markets. For a short period last fall that seemed to be in question.

What was your worst day in the middle of that, and what were your fears about TVA, in particular?

I don’t know that we had a “worst day.” In the height of the crisis in late September and early October we had a lower than normal amount of short-term debt, so the amount of short-term funding we had to do was significantly less than normal. In the funding we did, we found good demand for our short-term debt.

But when Treasury Secretary Paulson calls the CEOs of major Wall Street banks to his office and says, “You’ve got to sign this paper before you leave,” that’s got to be a pretty serious situation in the credit markets.

Considering that you were doing so well in the credit markets, what was your fear?

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. 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.

Do you have any worries about suppliers?

Not as much. We do credit assessments of all our major suppliers, and we try to execute contracts with suppliers that are the most credit worthy. Or if they’re not, we try to deal with ones who put up some form of credit assurance in advance, for situations like we had last fall. 

How has the credit crisis affected TVA itself?

We pretty much refrained from issuing any long-term debt during the last four or five months of 2008. We were in the market regularly with short-term debt issues, and we had significant demand for TVA short-term debt during this time frame. We issued short-term debt at record low levels, as far as the interest rate goes.

We actually had a $2 billion maturity due in mid November 2008 that we pre-funded earlier in three transactions from January 08 to June 08. When we pre-funded, we took the results of that funding and paid down short-term debt up till November. That lowered the amount of short-term debt by $2 billion in that September and October time frame.

Sounds like you had some foretaste of things to come.

Well, we certainly saw signs of concern early in the year. I don’t think anybody had a crystal ball about what was actually going to happen. But we basically saw some signs of concern, and we also saw interest rates that were very attractive to us on a long-term basis. We saw attractive long-term funding opportunities, and we decided to take advantage of them because we saw good investor demand for them at the same time we saw attractive low rates.

To what do you attribute the strong demand by investors for your short-term debt at the end of the year?

We’ve always have good demand for TVA’s short-term debt. But in particular there was a clear flight to quality in the fourth quarter of 2008 and we were a beneficiary of that.

Do you issue commercial paper?

We issue discount notes, which are very similar to commercial paper. Technically, discount notes can be issued for up to 364 days, while commercial paper is usually nine months or less. But they’re very similar.

Looking ahead in 2009, what’s your strategy in terms of managing your debt in the face of this crisis?

TVA is an opportunistic issuer. We’re always trying to stay abreast of the market and are looking for opportunities to issue debt, particularly at low interest rates. In the month of January, we’ve seen some improvement in the overall tone of the debt markets. Yesterday was clearly a good example. [On Jan. 29, $22.5 billion of investment-grade debt was issued, according to Bloomberg, which reported it as the busiest day on record]. We’re clearly seeing some improvement in the debt markets. They’re not back to where they were prior to the crisis, but I think we’ve seen some improvement.

How do you expect spend the proceeds of your debt offering this year?

We only invest money for a portion of our needs for new capital projects. That’s the only reason we go to the market; we do not borrow money to meet operating expenses.

Does the current uptick in the bond market give you optimism to plan future projects?

The lower the cost of financing the more favorable some potential projects could look. We’re completing a second unit at one of our nuclear plants that we actually started last year. It will probably be a five-year capital expenditure. Being an electric utility, we build long-lived assets. And we typically issue long-term debt in order to fund those assets.

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.