A canary call is a distinctive feature found in step-up bonds (e.g. Hubei Science & Technology Investment Group, 3.55% 10mar2040, CNY or Zhuhai Huafa Group, 4.43% 4nov2029, CNY) and fixed-to-floating bonds. In a canary call, the issuer of the bond retains the option to call back the bond, but this option is only available on a specified step-up date. After this point, the issuer cannot call the bond back. Typically, the first step-up date marks the transition to a higher coupon rate for the remaining periods.
So, during the initial period, a canary call bond pays an initial coupon rate. However, once the callable period is past, the issuer is bound by the bond's terms until it reaches its maturity date. In essence, a canary call transforms into a non-callable step-up bond, where the coupon rate progressively increases at each subsequent step-up period.
Importantly, the exercise of a canary call can only occur on predetermined dates, similar to a Bermuda option, where the option holder has the right to exercise the option at specific intervals throughout the contract's lifespan as well as to a European option, where the option can no longer be exercised before maturity, and the issuance parameters remain unchanged.
For issuers, one advantage of step-up bonds with embedded canary calls, is that such options offer protection against falling interest rates. However, this protective tactic ceases to be available once the first step-up period has passed, leaving the issuer with less flexibility.
Interest Rate Risk. While bonds with embedded canary call options can offer protection against falling interest rates, they can be less favorable in a rising interest rate environment. If rates rise significantly, the coupon rates of the bond may not keep pace with the broader market, potentially resulting in lower returns.
Issuer Risk. The creditworthiness of the issuer is a critical factor. If the issuer's financial stability weakens, it could impact the issuer's ability to meet their obligations, including paying interest on bonds featuring canary call options.
Steady Income. Investors can benefit from a predictable and steadily increasing income stream as the coupon rate steps up at predetermined intervals, providing a hedge against falling interest rates.
Resilience to Interest Rate Fluctuations. They are less susceptible to the impact of interest rate fluctuations compared to traditional bonds. This feature makes them attractive when interest rates are expected to remain stable or within a narrow range.
Predictability. The predetermined dates for the step-up make bonds with embedded canary call options more predictable for investors, providing a level of stability in income and return on investment.
Consider the following scenario: the company issues a seven-year bond with a canary call option. The initial coupon rate for this bond is set at 6 percent. The key feature of the canary call bond is that it has scheduled step-up periods. In this case, the rate steps up to 7 percent after three years, which marks the initial step-up period. Following this, step-up periods are scheduled every year after that.
Now, let's move to the four-year mark in the bond's life. At this point, the open-market interest rate has dropped to 5 percent. Given the lower market interest rate, the company would ideally want to call back the bond and refinance it at the more favorable market rate. However, here's where the canary call feature becomes important: the company will not be able to do so.
The reason is that the call-back option, which allows the issuer to redeem the bond early, expired after the initial step-up period, which occurred at the three-year mark. As a result, the company is committed to the bond's terms until its maturity, which is seven years from the date of issuance.
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