Issuers see call options remaining rare without guidelines clarifying tax status.

Detachable call options briefly reappeared in the new issue market last week for the first time since March, but industry sources say the transaction does not herald the product's return.

The inclusion of call rights in a $175 million issue of Valdez, Alaska marine terminal revenue refunding bonds permits the issuer to strip out and sell the right to call the bonds in the future, potentially gaining the benefits of a refunding at a lower cost.

But because of the unsettled tax status of detachable call rights, investors in the Valdez deal demanded a premium from the issuer of 5 basis points, or as much as $87,500 per year.

Despite the successful sale, the premium pricing has left most Wall Street purveyors of the product pessimistic.

"We have tried on five or ten occasions to include call rights language, but without success," said one underwriting official who did not work on the Valdez deal. "And given the pricing they got, I don't see much opportunity yet to try again."

Clarification of the tax laws involved could help reverse the situation, according to one derivative professional.

"The right combination of events could bring [detachable call options] back. The Treasury could publish new [regulations] or underwriters could hit on the right set of covenants," the professional said.

In the past, investors were willing to pay the same price they paid for ordinary bonds for issues brought to market with call rights language. But now that investors are seeking a premium for inclusion of the option, issuers have balked.

The Valdez deal was unusual in that the marine terminal's owner, BP Pipelines Alaska Project, Inc., would have to pay approximately $3 million in administrative costs to call the bonds early, a source familiar with the deal said. Most issuers would not face such hefty upfront costs to call their bonds.

Investors said that they are afraid that unresolved Treasury regulations might treat the future sale of call rights as a reissue. And some said they believe the bonds are less valuable than bonds that remain callable by the original issuer.

The fears are affecting the value of already-issued bonds containing call rights language. Such bonds trade at 5 to 10 basis points less than comparable, callable bonds that do not contain the language, according to several portfolio managers.

"I think the jury is still out on detachable call options," Dave MacEwen, a portfolio manager at Benham Capital Management, said. "I have no problem with the concept, but the taxability issue is still looming."

In some cases, a reissue could jeopardize the underlying tax-free status of the bonds, although most deals have included language requiring the issuer to obtain a legal opinion that the tax-free status would be preserved.

Investors said they are also concerned that a reissue could create a capital gains event for them. If a future sale of call rights triggered a reissue of the underlying bonds, investors holding those bonds would have to pay capital gains taxes at that time, even though they were not selling their bonds.

For example, a research report published by J.P. Morgan Securities in May reviewed the treatment of a bond sold that month with language allowing the future sale of call rights, under proposed Treasury regulations.

The example used a standard, twenty-year bond callable in ten years at 102 declining to par in 12 years and priced at par with an initial coupon of 5.80%.

If rates decline 20 basis points in the following three years, the bond's price would rise to 103.5 to yield 5.31%.

If at that time, the issuer stripped and sold its call rights on the underlying bonds, and the sale was deemed a reissue, bondholders would be liable for capital gains taxes on the $3.50 per $100 increase in value, even if they continued to hold the bond.

The Valdez issue included language designed to alleviate tax concerns, according to the deal's senior manager, First Boston.

"We're looking for that spread to decline to zero," D. Jeffrey Penney, vice president at First Boston, said. "We're trying to address people's concerns and get at the reasons for that spread."

To sell the call rights on the Valdez issue, the issuer would have to obtain a lawyer's opinion that the sale would neither jeopardize the tax-free status of the underlying bonds nor trigger a capital gains tax.

In the past, First Boston has immediately stripped and sold call rights at the same time the underlying bonds were issued. Others firms, notably PaineWebber, have relied on the inclusion of language allowing call rights to be sold in the future.

But with pervasive tax worries in the investment community, First Boston was not able to sell the Valdez call rights immediately.

Apart from the tax questions, some investors have also raised concerns about the relative value of bonds that had their call rights sold to investors at the time the bonds were sold.

Since such bonds cannot be called by their issuer, they cannot be pre-refunded, nixing a favorite investment strategy of buying bonds that might be pre-refunded. So, bonds stripped of their call right are less appealing for investors seeking so-called "pre-re" candidates.

Others claim that the sale of call rights makes the bonds less likely to be called than ordinary callable bonds. That would make them relatively more valuable since the holder would receive an above-market rate for a longer period of time than the holder of an ordinary bond.

If rates fall and the call option becomes valuable, instead of going through the expense of calling the bonds, the holder of the option could simply sell the option to capture the value.

Some claim that the sale of call rights would make the bonds more likely to be called. They argue that an investor holding the call option would be more likely to call the bonds than municipal issuers.

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