Ratchet Bonds

[Bedee2704]

Hello everybody,
there is a little note about so-called “Ratchet Bond” in Schweser Study Session 14 “Valuation and Analysis: Bond with embedded options”.
Due to the limited coverage in the mentioned paragraph and for the sake of detail, can someone explain the key on it.
There are talking about the rate can never reset higher or the embedded put in a rachet is never exercised when rates increase and so on.
I just want to understand the basic mechanics of the investor - variable cap - and the issuer option - contingent put!
I and maybe somebody else thank you!
Bedee

 

[S2000magician]

Ratchet bonds, in a nutshell:

• Coupon rate starts very high: much higher than the borrowing rate for the issuer.
• There’s a formula for resetting the coupon rate periodically.
  • The rate can remain the same or decrease at a reset date; it cannot increase.
• Whenever the coupon is reset lower, the bondholder has an option to put the bond at par.

You can think of the reset as a sort of call option: the issuer calls the existing bond and replaces it with another callable bond that has a lower coupon rate, and the same maturity as the existing bond.

 

[Bedee2704]

I thank you… the last paragraph of your reply nailed it.
Bedee

 

[krokodilizm]

I think it is the term ratchet that makes it confusing. The term callable, for instance, implies that it can be called. So what is a ratchet?
It is a mechanical tool that allows movement in one direction but not the other, so it is used to tighten ropes, bolts, nuts etc. Here’s is a ratchet used for strapping.
In corporate finance we also see a ratchet clause which allows target company management to increase its equity if they meet performance targets, but they don’t get penalized for otherwise.