DEFINITION of Extraordinary Redemption
An extraordinary redemption is a provision that gives a bond issuer the right to call its bonds due to an unusual one-time occurrence, as specified in the offering statement. Extraordinary redemptions, also called extraordinary calls, occur when bond proceeds are not spent according to schedule; when bond proceeds are used in a way that makes nontaxable bond interest taxable; or when a catastrophe destroys the project being financed, among other reasons.
BREAKING DOWN Extraordinary Redemption
Extraordinary redemption provisions are found in some municipal bonds which are issued to raise capital to fund certain projects for the betterment of the community. One type of a municipal bond is the revenue bond which has its interest payments and principal repayments backed by the revenue generated from the funded project. For example, a revenue bond may be issued to fund an airport and any revenue generated from the airport through fees, charges, and taxes will be used to service the muni debt. However, if an adverse event occurs in which the airport becomes inoperable, cash inflow will become nonexistent. In this case, the issuer will be unable to continue servicing the debt, and may choose to trigger the extraordinary redemption clause.
An extraordinary redemption means the issuer redeems the bond at par before the bond matures due to unusual circumstances that affects the source of revenue. The extraordinary event clauses can be either mandatory or optional, meaning the occurrence of an event can either require the company to redeem the bonds or the option can be opened up to the company. A more common circumstance under which a bond would be called, assuming it is provided for in the offering statement, is a drop in interest rates that allows the issuer to refinance its project by issuing new bonds at a lower rate. This provision may also be used to retire single-family mortgage revenue bonds or mortgage-backed securities (MBS) when a large number of homeowners refinance their mortgages. Examples of bonds with the extraordinary redemption feature are water and sewer bonds, housing bonds, and Build America Bonds (BAB).
Build America Bonds
BABs were issued for a short period beginning in 2010 at the height of the financial crisis as a way of helping municipalities retain solvency during the economic recession. The government offered issuers and bondholders a 35% federal subsidy of the interest payments through tax credits, reducing the issuer’s cost of borrowing and the bondholder’s tax liability. If the federal government were to fail to pay the promised 35% of the issuer’s interest payments or reduces this subsidy, the extraordinary redemption provision could be activated and the bonds could be redeemed at any time. In fact, when the government reduced the subsidy interest from 35% to 28%, some issuers immediately acted and called in their high coupon bonds and issued new bonds at the lower rate to replace them. The Build America Bond program ended in 2010.
Extraordinary Redemption vs. Regular Calls
A regular or fixed call is scheduled and can be exercised by the issuer if interest rates drop to a level that makes bond refinancing financially beneficial to the issuer. The trust indenture lists the call date(s) that the issuer can redeem the bonds on. Bonds cannot be redeemed before these dates. An extraordinary redemption, on the other hand, is a call option which gives the issuer the right, but not the obligation, to call the bonds when certain triggering events occur. The bond retirement is unscheduled and can only be called as a result of a certifiable catastrophic event, usually prior to the completion of the project.