Financial Executives Online

Others might ask just what FAS 133 problems putable/callable bonds potentially raise. But in actuality, and courtesy of an interpretation from the Financial Accounting Standards Board's Derivatives Implementation Group (DIG) last year, the answer is none. Although a cloud of uncertainty hung over putable/callable bonds with the approach of FAS 133 implementation in late 1999, the DIG eventually ruled that because the embedded short option relates to interest rates, as does the underlying price behavior of the bond, there is no need for a corporate issuer to mark the sold embedded Treasury option to market. After this proclamation, new putable/callable bond issuance boomed.

But there is a second small problem that corporations often ignore: the tax consequences of these products. Let's assume a company issues 10-year debt with a 2-year put/call reset that normally would have carried a 6.6 percent yield for an all-in cost of 6.0 percent. The nominal coupon on the debt might still read 6.6 percent, and the 60 basis points would come from a separate payment to the corporation by the investment banker. If, after two years, the short option ends up out of the money, the company must book a windfall gain on this short option, and this windfall is taxable as income.

This leaves the company having paid 6.6 percent and receiving something less than 60 basis points net of taxes for the short option risk. The after-tax cost of funding is actually higher than the advertised 6 percent rate. Meanwhile, if the option is in the money and at a loss, the added cost that the company is out of pocket can only be amortized over the subsequent 8-year stub period of the paper - not a great deal.

In short, corporations, looking at terminal break-even spreadsheets may think these products look sexy and attractive on an up-front basis, but there are a few uncertain back-door costs. In addition, though rates may seem low to most corporate treasurers at present, there is also still the risk of suffering a true black eye if rates were ever to fall to super-low levels in the United States as has happened in Japan over the past decade.

Many derivatives-savvy treasurers recognize some of these pitfalls. "I have seen a number of these structures presented to me," says one consumer goods company treasurer, "but I honestly don't like these things. At the end of the day, they represent a speculative instrument and an additional bet on the direction of interest rates that I just don't need."

But elsewhere, a more general attitude has been: Why not sell that extra option, get cheap money for a few years, and worry about the resetting exposure later on? "We didn't understand this product at first," says one Ontario-based treasury staff member. "We studied it, ran the numbers, and, in the end, we liked the comparative interest rate savings we could achieve. We'll worry about the resetting when we get there."

In the case of Nabisco, assistant treasurer Benjamin Boykin, working under former Nabisco Treasurer Frank Souzzi, agreed to issue a boatload of these bonds a few years ago. But Nabisco has since been acquired by Philip Morris Cos., Inc. Now it's someone else's problem if these securities have gone awry on the back end, as it appears may have occurred. Andrew Kalotay, president of consultant Kalotay Associates believes Nabisco would have faced a $100 million mark-to-market loss had the DIG ruled that putable/callable reset bonds needed to be bifurcated and marked to market. Instead, Philip Morris' funding costs will now run just a tad higher than they otherwise would have been had Boykin previously been less impetuous.

Overall, one thing is for sure: If interest rates ascend from here, all the treasurers currently hopping on putable/callable bonds will outwardly appear pretty smart. They will have raised relatively cheap money with no added pain. But if rates decline, a few back-door surprises may still lurk. Given the pace at which treasury officials sometimes move around internally or switch firms, maybe this doesn't matter much. But when your friendly bank structurer comes touting the next greatest thing since sliced bread, be sure you understand that there's often a hitch.

Barclay T. Leib is the president of Sand Spring Advisors LLC, a New Jersey-based financial consulting and alternative asset management company. He may be reached at BTLEIB@Sandspring.com.