What is Canary Call?
- A canary call is a type of step-up bond where the coupon rate increases at predetermined dates and that is not able to be called after a certain stated period.
- Canary calls are more attractive to investors as the issuer loses the call advantage once the first step-up period has passed.
- Canary calls are especially appealing to investors when interest rates are expected to be flat, or confined to a narrow range.
Understanding Canary Call
With a canary call, the issuer of the bond reserves the option to call back the bond until the stated step-up date, but cannot call it back after that point. Usually, the stated period is the first step-up date after which the coupon moves up to a higher rate for the remaining periods.
So, after a canary call pays an initial coupon rate for the first designated period, the issuer is stuck with the terms until the bond reaches its maturity date. Essentially, once the callable period is past, a canary call reverts to a non-callable step-up bond, where the coupon rate will increase with each step-up period.
A canary call may be exercised only on predetermined dates. In that way, it is similar to a Bermuda option, where the holder has the right to exercise that option at pre-determined intervals, or dates, through the lifespan of the contract.
One advantage for issuers of step-up bonds is that it offers them a protective tactic against falling interest rates. With a canary call option, the issuer loses that advantage once the first step-up period has passed. Canary calls can make step-up bonds more attractive to investors.
Step-up bonds are attractive to investors because they are not impacted as much by interest rate fluctuations as are traditional bonds. Step-up bonds in general, and canary calls in particular, are especially appealing to investors when interest rates are expected to be flat, or confined to a narrow range.
Canary Call Example
Consider the following scenario: Acme Company issues a seven-year bond with a canary call option. The initial coupon rate is 6 percent. The rate steps up to 7 percent after three years, which is the initial step-up period. Subsequent step-up periods are scheduled every year after that.
At the four-year mark, the open-market rate has dropped to 5 percent. At this point, Acme Company would love to call the bond and reissue the debt at the lower market interest rate. However, Acme will not be able to do so, as the call back option expired after the first step-up point, which occurred at the three-year mark.