How does it help to make callable bonds floating if not called?

Question

As I understand it, fixed-rate callable bonds are often structured in such a manner that if the bond is not called on its first call date, the bond becomes a floating variable bond.

This, I imagine, is a mechanism meant to ensure that these bonds are indeed called even if interest rates rise, as then so do the coupons that the issuer has to pay.

But what if interest rates FALL instead? Then the issuer will have to pay less coupons, and so might decide to not call after all.

So how does this "mechanism" help at all to ensure that it is called? It seems to be a null-sum game.

Answer 1

Bond issuers generally don't want floating rate bonds, since it puts the risk of interest rates going up on them. Ask anyone who has held a variable rate mortgage recently how it feels when their mortgage rate goes up 4 points. So it makes sense that bond issuers would rather call their bonds rather than letting them turn into floating rate bonds.

But what if interest rates FALL instead?

The same holds; if interest rates fall, they can go back up, and bond issuers generally don't want that uncertainty.

It doesn't ensure that they get called, but it makes them much more likely to.

Answer 2

I have been investing in bonds for over 40 years now. I have never seen a fixed rate bond that becomes a variable rate bond after it becomes callable. However, I could certainly believe such a bond exists.

What I have seen is bonds with a sinking fund. Here the debtor must redeem a fixed percentage of the bonds. The bonds redeems are selected at random so to the holder of the bonds, it is a lottery and if your bond is selected then your bonds are called in.

I also remember the days where callable bonds would have a call premium with 3% being typical. Hence if they called the bond early, you got a premium. Today, I am not seeing a lot of bonds, with that kind of call premium.

I have seen bonds where the interest rate increases over time. The idea here is that if interest rates rise then the buyer is protected. I have never bought such a bond because they typically have bad call features. However, the increasing interest rate does protect the buyer if it is not called. From what I have seen, these bonds tend to be called a few years after they are issued. When I am buying a bond, I would like to buy a bond that I can keep for 8 years or more.

I feel that a call feature, to the buyer of the bond can be described as heads your lose, tails they win.

I am in the United States and the rules could be significantly different in your country.