Ratchet

CFA Level II
#1

Hi,

There is something I am confused about with Ratchet bonds. I understand the process.

If coupon rates fall below the previous level the issuer benefits by now having to pay pay lower coupons to the investor.

But the investor also has an option here to put the bond back at Par. Firstly, can someone explain which situations an invesor would do this? Surely no investor is willing to accept lower coupons and therefore would always excercise this option when it falls below a rate? Or would they perhaps think it through more as if they put it back then they will not be able to get a better coupon elsewhere as the new coupon low is say the market rate.

Essentially then, what reason is there to have this double option in place and I do not see how it benefits the investor in any way, unless i am missing something obvious.

Thanks

#2

If rates drop the investors bond would be worth more, using the issuer option they can use the ratchet to reset the rates to whatever is determined in the offering docs. When they do that, it allows the put given the inverstors to be used if rates increase again and their bonds lose value. Most of the specific terms that go along with this would be in the offering docs.

You would also likely price in the fact that its possible you would be receiving lower coupons, but at that point you also gain a put which would add value to your bond.