Rate Trigger
What it is:
How it works (Example):
Let's say Company XYZ issued a bond with a 10% coupon rate this year. The bonds mature in 10 years. The bonds are callable, meaning that Company XYZ can pay the bonds off early.
Now let's assume that three years go by and interest rates have fallen considerably. Company XYZ talks to investment bank ABC and learns that it could issue bonds at just 5%. This would save it millions in interest expense.
Accordingly, the 5% acts as a rate trigger, and Company XYZ decides to borrow the money and use it to pay off the 10% bonds seven years early. The people who owned the 10% bonds get their money back, but they lose out on seven more years of 10% coupon payments.
Why it Matters:
Rate triggers prompt change. They have major effects for investors who hold callable securities, because their issuer has an incentive to call the securities in order to save money.
