Extraordinary Redemption

What is Extraordinary Redemption?

An extraordinary redemption is a provision that gives a bond issuer the right to call their bonds due to an unusual event, such as a catastrophe that impacts the source of the bond's revenue. An extraordinary redemption feature must be specified in the bond's offering statement.

Understanding Extraordinary Redemption

An extraordinary redemption means the issuer redeems the bond at par before the bond matures due to unusual circumstances that impacts the source of revenue. Extraordinary event clauses can be either mandatory or optional, meaning the trigger event can either require the company to redeem the bonds or give the company the option to do so. Terms of an extraordinary redemption must be outlined in the bond's offering statement.

A common circumstance under which a bond could be called is a drop in interest rates, which would allow the issuer to refinance 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 when a large number of homeowners refinance their mortgages. Examples of bonds with extraordinary redemption features are water and sewer bonds, housing bonds, and Build America Bonds (BABs).

Extraordinary redemption provisions are found in some municipal bonds. One type of a municipal bond is the revenue bond, which is repaid from the revenue generated from the project it funds. For example, a revenue bond may be issued to fund an airport, with revenue generated from gate fees, charges, and taxes used to service the debt. However, if an adverse event impacts the airport's ability to generate revenue, the issuer could elect to trigger the extraordinary redemption clause.

Extraordinary redemption, also called extraordinary call, is most commonly exercised if:

• bond proceeds are not spent as outlined
• bond proceeds are used in a way that impacts the tax status of the interest earned
• a catastrophe affects the project being financed

Build America Bonds (BABs)

BABs were issued in 2010 as a way of helping municipalities maintain solvency during the economic recession. The government offered issuers and bondholders a 35% subsidy of the interest payments via tax credits, reducing the issuer's borrowing costs 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 reduce the 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 from 35% to 28%, some issuers immediately acted and called in high coupon bonds and replaced them with new bonds issued at the lower rate.

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 or dates on which the issuer can redeem the bonds. 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 trigger 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.