What is a Canary Call?
A canary call is a step-up bond that can't be called after a certain period.
How Does a Canary Call Work?
A step-up bond is a bond with a coupon that increases (“steps up”), usually at regular intervals, while the bond is outstanding. Many step-up bonds are issued by government agencies like Fannie Mae or Sallie Mae.
Let’s consider a five-year step-up bond issued by Company XYZ. The coupon rate might be 7% for the first two years, increasing to 8% for years three and four, and 9% in the fifth year. Note that the initial coupon rate on a step-up bond is usually above market.
Many step-up bonds are callable, which gives issuers some protection against falling interest rates. In a canary call, the bond can't be called after the first step-up.
For example, if after three years the Company XYZ bond is paying 8% but market rates are down to 5% (Scenario A), Company XYZ would pay a relatively high interest rate on its debt. In fact, if rates simply stay the same (Scenario B), Company XYZ might like to call the bond. Conversely, if market rates rise to 10% (Scenario C) and Company XYZ gets to pay only 8% for its debt, well, then it’s getting a deal. note that in scenarios A and B, Company XYZ would probably like to call the bonds and reissue the debt at a lower rate, but because of the canary call, it can't.
Why Does a Canary Call Matter?
There are several advantages to step-up bonds: They offer coupon payments that somewhat offset inflation, they usually come from high-quality issuers, and they are fairly liquid. Another advantage is that they lessen the interest-rate risk for the investor: The increasing rates provide a better yield to an investor than a fixed-rate note (as long as the bond is not called).
Some investors view step-up bonds as buy-and-hold investments because they are less sensitive to interest rate changes than traditional bonds are. Canary calls only strengthen this. For this reason, step-up bonds are more attractive when rates are expected to rise quickly and to a level above the step-up rates. This, of course, requires research and some speculation on the investor’s part.