Rate Trigger

What Is Rate Trigger?

Rate trigger is a drop in interest rates that is significant enough to compel a bond issuer to call their bonds, prior to maturity, in order to reissue at the lower rate and reduce their interest expense.

Understanding Rate Trigger

In the purest sense, 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.

Calling away can only be done if the bond issue includes a call provision in the offering. "Call" refers to the early redemption of a bond by the bond’s issuer. 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.

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 an investment subject to interest rate risk. If interest rates fall, the borrower (issuer) may call the existing bond in favor of issuing another one at the lower interest rate. The rate trigger is set when the bond is issued and is the level where the lender knows that the bond is likely to be called. Rate triggers, in the long run, save the borrower money. 

However, the bondholder is forced to go to 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 obtain another similar instrument that generates the same payouts that they were receiving from the called issue.

Rate Trigger Example

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 they would have received over the remaining life of the bond.

This example demonstrates the risk and rewards of callable security in the event of a rate trigger. Prior to the company calling its bonds, the investor could look forward to earning an above-market interest rate. The 2023 rate trigger realizes the market risk of a callable bond, resulting in lost interest income.