Canary option

What is Canary Call?

A сanary сall is a specific type of step-up bond. In a сanary сall, the initial coupon rate is set, and this rate is subject to periodic adjustments at predetermined dates. Unlike some other bonds, once a certain stated period, typically three years, has passed, the issuer cannot call or redeem the bond before its maturity date.

This feature distinguishes сanary сalls from traditional bonds, making them particularly attractive to investors in a falling interest rate scenario. Investors can take advantage of the step-up feature to benefit from increasing coupon rates over time, which can enhance the value of their investment. This exercise style, which restricts the issuer from calling the bond early, provides a level of predictability for the bondholder, offering more stability in income and return on investment.

Canary Call Explained

A canary call is a distinctive feature found in step-up bonds. In a canary call, the issuer of the bond retains the option to call back the bond, but this option is only available until 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.

One advantage for issuers of step-up bonds, like canary calls, is that they 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.

For investors, canary calls and step-up bonds, in general, offer an attractive proposition. These bonds are less susceptible to the impact of interest rate fluctuations compared to traditional bonds. They become particularly appealing when interest rates are expected to remain relatively stable or within a narrow range, providing investors with a degree of predictability and an opportunity to benefit from increasing coupon rates over time.

How Canary Call Options Work?

A canary call operates as follows: If a bond issuer decides not to exercise their right to call back the bond until the completion of the first-step period, they lose the ability to do so. In this scenario, the bond remains a step-up bond and continues to adjust to a higher interest rate for the remaining period as stipulated in the bond’s terms. The specific dates on which the step-up bond can be called under a canary call are clearly defined when the bond is issued.

Step-up bonds, including those with a canary call feature, offer issuers a valuable opportunity to protect themselves against a decline in interest rates. However, this protective measure ceases to be available once the initial step-up period has been completed. At that point, the issuer is locked into the bond’s terms until its maturity date.

For investors, a step-up bond with a canary call is often appealing due to its resilience against the fluctuations in interest rates that are commonly found in traditional bonds. This feature provides a level of predictability for investors, making it an attractive option when interest rates are expected to remain relatively stable or within a narrow range.

Risks and Benefits Associated with Investing in Canary Call Options

Risks

1. Lack of Liquidity. Canary call options may not be as liquid as other more conventional investment options, which can make it challenging to buy or sell them when desired.

2. Interest Rate Risk. While 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.

3. 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 canary call options.

Benefits

1. 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.

2. 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.

3. Predictability. The predetermined dates for the step-up make canary call options more predictable for investors, providing a level of stability in income and return on investment.

Why Do Canary Call Options Matter

1. Protective Tactic Against Falling Interest Rates. Canary call options provide issuers with a valuable protective tactic against declining interest rates. In a scenario where interest rates are on the decline, issuers can benefit from the ability to call the bond back and refinance it at a lower interest rate. This feature allows them to manage their debt more efficiently and reduce borrowing costs.

2. Resilience to Interest Rate Fluctuations. Investors find canary call options appealing because they are less affected by fluctuations in interest rates compared to traditional bonds. The step-up feature ensures that the coupon rate increases at predetermined intervals, offering investors a level of predictability in terms of income and returns. This predictability can be particularly attractive in an environment where interest rates are expected to remain relatively stable or within a narrow range.

3. Diversification. Canary call options provide an opportunity for investors to diversify their portfolios. By including these bonds in their investment strategy, investors can spread risk across different asset classes, reducing their exposure to any single type of investment.

4. Enhanced Returns. The step-up feature of canary call options can potentially lead to enhanced returns over the bond’s life. As the coupon rate increases at specified intervals, investors may benefit from a gradually increasing income stream, which can contribute to higher overall returns on their investment.

Canary Call Option Example

Consider the following scenario: Acme 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, Acme 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: Acme 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, Acme is committed to the bond’s terms until its maturity, which is seven years from the date of issuance.