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Putable/callable reset bonds. Term-enhanced remarketable securities - or TERMS, for short. These products may carry different names at different Wall Street investment banks, but if you're a corporate treasurer, and you haven't been exposed to a marketing pitch on putable/callable synthetic debt, consider yourself the exception. Putable/callable reset bonds are red hot.

According to literature from Credit Suisse First Boston, U.S. corporations have issued more than $45 billion in "synthetic putable" debt since 1996. The driving force behind these products' popularity has been the twin combination of low interest rates and high implied volatilities in the fixed-income option market. More recently, a contributing factor has been the relatively wide swap premiums for long-dated corporate debt that many treasurers are unwilling to pay on a simple outright basis.

Here's how the product specifically works. XYZ Corporation is going to issue some debt. The company is relatively indifferent between issuing 2-year paper or 10-year paper, but very concerned with keeping its funding costs as low as possible.

Enter a Wall Street structurer. He or she invents a security that typically has a 10-year nominal horizon but some special put and call features two years out. Specifically, the investor in this paper, via a trustee, has a mandatory obligation to put the paper back to the issuer in two years if interest rates go up, and the investment banker has the right to call the paper and remarket it to the public as a new 8-year security if interest rates go down.

Sound complicated? Actually, it's not really complex. Because the security either gets put or called in two years' time, no matter what interest rates do in the interim, what the company effectively has issued is a two-year bullet obligation to the put/call date. The only tricky part of the product is that to lower up-front funding costs, the company has also effectively sold its investment banker a call on a hypothetical 10-year treasury security.

If rates go up, the debt issuer pockets the premium on this call option, effectively lowering funding costs for the first two-year borrowing period. If rates go lower, the company will owe its investment banker some money on the hypothetical T-note call option sold. But the investment banker then graciously promises to roll this loss into a new issuance of bonds. In the remarketing process, a new price and coupon are determined by the market that will not only extend the debt another eight years, but will also pay off the intrinsic value on the issuer's previously short call option position.

Many corporations, including Nabisco Group Holding Corp., General Motors Acceptance Corp., Bell South Corp., Texas Utilities Co. and Ford Motor Credit have used these products. The first wave of putable/callable debt excitement blossomed in 1996, but carried on well into 1998. In that latter year, Canadian National Railway Co., while considering financing alternatives to acquire Illinois Central, decided that it liked the idea so much, it would push the whole maturity structure out even further. That company issued $250 million of 38-year debt with a put/call feature eight years forward. Later that same year, Ford Motor issued $375 million with a 13-year time horizon that has its put/call reset date coming up this October.

The great attraction of putable/ callable debt is the comparative cost of funds once one adds in the premium receipt on the embedded short call option. In CSFB's brochure, for example, the firm discusses a 12-year bond with a 2-year put/call date. In this example, on a terminal break-even basis, the corporate treasurer doesn't know whether he or she will end up with 2-year money at 4.56 percent or 12-year funding at the equivalent of 6.32 percent, but in either case, the company's cost of funds will be lower than the current straight 2-year rate of 5.41 percent or 12-year paper at 6.90 percent. It would appear to a neophyte that you'd save approximately 60 basis points either way.

The rub, of course, is that for the 60-basis point savings, the corporate issuer always ends up with the least advantageous long-term position. If rates go up and it turns out the treasurer should have borrowed long, another round of financing will be needed in two years' time. If rates go substantially lower, the treasurer is effectively locked in from the short treasury call to the equivalent of having already issued long-term securities.

In the latter instance, the treasurer will also still face a somewhat nebulous refinancing situation when the reset hits. What happens if interest rates have plunged and the corporation owes the investment banker $20 million in intrinsic value on the short T-note call? That cost will have to be built into issuing a new piece of paper at a sufficiently high above-market interest rate so as to be issued at a premium to par, and thereby maintain the corporation's funding while also reaping enough money to pay back the investment banker. If the corporation's credit spread to the market has deteriorated in two years, that, too, could cause added problems.

The problem the investment banker is unlikely to highlight to the issuer up front, however, is that this subsequent debt issued significantly above par almost always must carry a 10-15 basis-point yield enhancement in order to attract buyers. If remarketing is necessitated, this means at least part of the up-front cost savings the treasurer thought the putable/callable reset bonds offered will be lost. In addition, this added cost would also be spread out over a far longer period.

"For this reason, the majority of putable/callable bonds that have been in the money don't actually get remarketed," says one investment banker. "To date, the majority have simply been retired with a cash settlement to the investment banker, or exchanged for a whole new issue of debt carrying a greater notional value." In other words, instead of issuing 10-year debt for $100 million carrying an off-market interest rate so as to be issued at 105, companies tend to issue new bonds at par totaling $105 million and carrying a market rate. The extra $5 million received then goes to the investment banker to settle the in-the-money option that the corporation had previously been short.

Some might ask why the investment bankers don't simply provide for such a debt exchange explicitly in a bond's initial prospectus - if indeed this is the route many companies follow. The answer is that the SEC does not allow language in any prospectus that potentially changes a notional amount of debt outstanding. It can only be changed after the fact via a completely new issue.