What it is:
A canary call is a step-upthat can't be called after a certain period.
How it works/Example:
A step-up bond with a that increases (“steps up”), usually at regular intervals, while the bond is outstanding. Many 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 . that the initial coupon rate on a step-up bond is usually above .
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 . 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 and reissue the debt at a lower rate, but because of the canary call, it can't.
Why it matters:
There are several advantages to inflation, they usually come from high-quality issuers, and they are fairly . Another advantage is that they lessen the interest-rate risk for the investor: The increasing rates provide a better to an investor than a fixed-rate (as long as the is not called).
Some investors view step-up bonds as buy-and-hold because they are less sensitive to interest rate changes than traditional 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.