What is a Canary Call?

A canary call refers to a step-up bond that cannot be called once a certain period elapses. After the step-up bond has completed its first-step period, a call cannot be made. A step-up bond is a bond that pays investors a low interest rate at the initial stage but the coupon (interest) increases at regular intervals. The coupon rate moves higher for the remaining period of the bond. A canary call prohibits an issuer from calling back a step-up bond after its first step has been reached. When the first step is reached, the bond issuer can call back the bond, but after the first-step period has been completed, the bond cannot be called.

How Does a Canary Call Work?

In reference to a canary call, if a bond issuer decides not to call back the bond until the first-step is completed, the call cannot be made. This means the bond remains a step-up bond and continues to step up to a higher interest rate for the remaining period. The dates at which a step-up bond under a canary call can be made is clearly stipulated in the issue. Step-up bonds typically avail issuers a chance to hedge against decline in interest rates, however, once the first-step period has been completed, this protective measure expires. A step-up bond with a canary call is often attractive to investors due to the benefit of not being affected by fluctuations in interest rate commonly found in traditional bonds.

Example of a Canary Call

The illustration below will aid a better understand of canary call; Investor A buys and holds a step-up bond with a canary call option from Issuer B. The initial coupon rate of the bond is 6% and has a life-span of seven years and a step-up period of 2-3 years interval. If the bond issuer does not call the bond at the first-step period and the coupon rate of the bond increases to 7% after two years, that bond can no longer be called back.