A mechanism that would give investors, rather than issuers, the right to call tax-exempt bonds is picking up steam in the municipal market.
These detachable call options made their market debut in a $67.3 million Las Vegas bond issue last spring. Since then, more than $2.2 billion of other deals have incorporated the feature into some of all of their maturities, according to one estimate. And for the first time last month, the Municipal Electric Authority of Georgia actually sold the call rights to investors on $72 million of bonds in a $316 million bond issue.
Investment bankers say the call option twist could provide an attractive alternative to other refinancing mechanisms, such as advance refundings. Creating a separate over-the-counter market for the call options also might lead to more efficiency in how the market values such features as noncall protection, the bankers add.
But as with any other nascent market, participants can probably expect some bumps as they move along the learning curve.
For example, some concern exists over proposed internal Revenue Service rules that clarify when outstanding municipal bonds are considered to be reissued, bankers said. They noted that the rules could have an impact on call options in certain circumstances such as refundings, where issuers invest a significant amount of proceeds at a restricted yield and do not exercise the right to sell the call immediately.
Differing Opinions
Investment bankers, competing to establish a foothold in the call option field, also have differed recently over the mechanism's use, specifically over when the timing might be best for an issuer to exercise its rights to sell the option.
Accordingly, the next year or so likely will be an important period for both developing and refining the call option concept in the municipal market, market sources said.
Municipal issuers traditionally have held the sole right to call their bonds, generally structuring their issues to include a redemption option after 10 years. In exchange, investors usually have required slightly higher yields to accommodate calls, and the call price often initially includes a premium over par.
But investment bankers have studied possible alternatives to that process, partly in response to changing federal tax laws that impose advance refunding restrictions on issuers. Those restrictions have hit private-activity issuers. hardest.
As an initial response to those restrictions, such issuers have increasingly relied on municipal forward transactions, which essentially serve as synthetic advance refundings to lock in low yields on future financings.
But Jeffrey Holt, a vice president of PaineWebber Inc., observed that the municipal forward structure could cost issuers upwards of 100 basis points over current market yields. As a result, Holt said, he developed the detachable call option concept for PaineWebber in the hope that it would provide more efficiency for issuers.
Las Vegas Breaks Ground
Detachable call options represent "a different way to skin the cat," said Holt, whose firm served as sole manager on the ground-breaking Las Vegas deal.
The Las Vegas deal basically resembled a regular issue, down to terms that included a first call date in 10 years. The new call option provision simply gave the city the ability to sell its right to call the bonds to a third party.
City Manager William Noonan praised the provision at the time for giving Las Vegas future refinancing flexibility, even though a market for the call options did not yet exist.
In particular, Noonan observed that a call option sale could do away with expenses such as issuance fees. Those fees, he said, can cost Las Vegas about 20% of the savings it might gain from locking in lower rates through an advance refunding.
A call option sale in theory is more efficient. Rather than locking in lower rates, an issuer would instead extract savings by selling the call options to interested investors.
Las Vegas plans to ask the Nevada Legislature in its 1993 session for explicit authority to offer the call options. But bond lawyers said many issuers may not need to go through that process since modern statutes generally accommodate the authority. Many issuers with home rule or charter powers also might possess the right to sell the call options, they said, or could amend their ability to do so.
Since the Las Vegas development, the Municipal Electric Authority of Georgia deal has generated widespread discussion in the market. On the one hand, participants commended the issue for proving that the call options can be sold. But some participants questioned the wisdom of the utility's decision to sell the options immediately, asking whether the sale generated adequate savings.
Officials at First Boston Corp. and J.P. Morgan & Co., which served as co-agents in structuring the call option sale for the utility, defended the transaction, saying it made sense in this particular case.
G. Gregory Usry, a vice president at J.P. Morgan, said an issuer has to ask, before selling its call option, whether it instead wants "to retain the flexibility to do a current refunding in the future or retain the flexibility to change [language in] documents."
In the utility's case, Usry said, maintaining that flexibility was not a major issue, especially since the options sold affected only a tiny portion of its overall bonds outstanding.
In some cases, however, Usry said the product may not be something "that every issuer should or could take."
Proceeds from the call option sale enabled the authority to reduce the size of its borrowing slightly and saved it at least a handful of basis points over selling straight noncallable debt, according to First Boston and J.P. Morgan.
Some market participants questioned that assertion, saying their own calculations indicated that the utility came much closer to simply breaking even compared to yields they would have been achieved by selling noncallable bonds in the first place. This also questioned whether the savings were adequate to compensate for the loss of flexibility by selling the call right.
Such differences of opinion are likely to flare up again as the market evolves through actual sales of the call option rights. In virtually all of the deals to date featuring detachable call options, issuers have chosen not to sell the option immediately. In some instances, however, uncertain legal authority may have been an impediment to such sales.
But some tax questions also are arising for issuers who build the detachable call options into their deals with the expectation that they might sell them later if market conditions are favorable.
This concern centers on proposed rules published this month by the IRS that clarify when outstanding municipal bonds and other debt instruments are considered to be reissued and subject to stricters current tax laws.
Federal officials have said the proposed rules could adversely affect existing call-waiver transactions, which are structured to allow the issuer to waive its right to call the bonds in return for a payment.
Holt of PaineWebber and other market participants said they are concerned the rules could be interpreted to treat detachable call options as reissuance when they are actually sold.
"The jury's still out" on certain meanings of the proposed rules, but such concern is probably warranted, said George Wolf, a partner at the bond law firm of Orrick, Herington & Sutcliffe.
Holt said the provision should not be a concern for many existing new-money deals featuring the call options because the bond proceeds generally are spent quickly.
But, Holt added, the provisions could raise concerns for refunding transactions that anticipate future sales of call options, primarily because such transactions involve bond proceeds invested at restricted yields. If the option sales triggered reissuance questions, issuers could then be faced with the need for complex retroactive adjustment of yields on all of the invested bond proceeds.
Holt said the ironic result of such an interpretation is that issuers, if able, would turn to advance refundings instead, thereby undermining the goal of Treasury officials to discourage excess bond sales.
Detachable call options could be the Treasury's "best friend" in cutting down on tax-exempt bond issuance, Holt said.
Advance refundings leave two separate bond issues outstanding, at least until the higher yielding issue can be called. But a bond lawyer said Treasury officials may weigh that fact against the alternative, that higher yielding bonds could remain outstanding until their stated maturity if call options are sold and the bonds remain unredeemed.
In any event, numerous market participants said they would prefer clearer direction on the matter from the IRS. During a comment period on the proposed rules, they said, some also might try to sway the IRS against treating a call option sale as a reissuance.
Actual sales of the call options might proceed slowly until enough potential investors are comfortable with the concept. Bankers are touting the product as a way to hedge call risks in portfolios. The ability to extend the duration of maturities also could appeal to sophisticated investors who hope to profit from a synthetic noncallable instrument that they could either hold or sell at more attractive levels in the future.
One thing seems certain -- many more tax-exempt deals incorporating the call option feature will start appearing. And market participants say this should be a healthy development for issuers.
As the market evolves and participation increases, it will "make sure the municipal market fairly values noncallable bonds," observed Bradford Higgins, a managing director of First Boston.
