What is a Rate Trigger
A rate trigger is a drop in interest rates significant enough to cause a bond issuer to call its bonds before maturity. Call refers to the early redemption of a bond by the bond’s issuer.
Calling away can only be done if the bond issue includes a call provision in the offering. The call provision often consists of a date by which calls must be complete. A bond with a callable period is not eligible for calls before that date. Callable bonds typically offer a higher coupon rate and a call price above par value to make them attractive to potential investors.
BREAKING DOWN Rate Trigger
A rate trigger is a type of trade trigger which, when reached, will cause an action to take place. In the case of a bond, the rate trigger may be dropping interest rates. A decline in prevailing interest rates leads an issuer of a callable bond to call that bond. Fluctuations in interest rates have implications across the economy but can be especially impactful in the bond market.
Many investments are subject to interest rate risk, also known as market risk. Interest rate risk is the hazard that an investment will lose value due to the relative attractiveness of declining prevailing rates. A bond with a fixed coupon rate is one example of investment subject to interest rate risk. If interest rates fall, the borrower may call the existing bond in favor of issuing another one at the lower interest rate. When the rate trigger, set at issue, realizes that risk the bond is called. In the long run, this strategy will save the borrower money.
However, the investor who held the note now must go into the marketplace to replace the called away investment. A danger to bondholders is reinvestment risk or the chance that investment options available to the investor after a bond's calling are not as attractive as the original bond. In a market with falling interest rates, it is unlikely the investor will find the same profits as they were making with the previous issue.
A Rate Trigger Turns Market Risk into Lost Interest Income
On January 1 of 2018, Company ABC offers 10-year callable bond with an 8% coupon rate, callable at 120% of par value. The callable date is January 1, 2022.
Interest rates rise and fall between the issue date and the callable date but remain close to 8%. On the first day of 2023, interest rates dip to 5%. This drop is a rate trigger.
Company ABC closes a deal to offer new debt at 5% and will use the proceeds from this offering to repay its 8% bondholders as they call away the bond. Company ABC exercises the option on the 8% bonds.
The investor receives $1,200 per $1,000 bond. However, the bondholder loses, the $400 of interest payments which they would receive over the remaining life of the bond.
This example demonstrates the risk and rewards of callable security in the event of a rate trigger. Before the company calling its bonds, the investor enjoys an above-market interest rate. The 2023 rate trigger realizes the market risk of a callable bond which results in lost interest income.