Why Fixed-to-Floating Callable Bonds Use Punitive Extension Coupons

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


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












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 by Dimitri Vulis (score 2, accepted)

https://quant.stackexchange.com/a/79795

To add further to dm63's comment, if you look carefully at the bonds structured this way, you will notice that they become not floaters paying index + some reasonable credit spread, but rather some very huge punitive spread, or in a few cases gearing. E.g. imagine a 10NC3 fixed-to-float bond. If at inception the issuer could borrow for 3 years at SOFR+150, so the fixed period pays the equivalent of just that, and the remaining years if not called, would perhaps pay SOFR+900 until maturity. The bond holder would be very happy to receive SOFR+900 for 7 more years, but this is very unlikely to happen. In 3 years, no matter what happens to the interest rates, the bond issuer is expected to be able to refinance at much less than SOFR+900 and to call this bond - unless their credit quality so seriously deteriorates and their credit spread widens so much that they might not be able to repay at all.

The goals are: the bond, based on its maturity date, can be reported as "long-term debt" on financial statements, which looks better than short-term debt, unless one looks more closely at the bond than financial analysts usually do. The bond investors, on the other hand, recognize that the call is very likely to be exercised, and demand lower coupon rate that they would for truly long term debt.

Credit spread typically have little term structure. If they can borrow at SOFR+150 for 3 years, they can probably also borrow at SOFR+180 or less for 10 years, so this isn't the main motivation for such structuring.

People who look at the ratios of various financial items to short-term and long-term debt, and naïvely misclassify this bond as long-term, based on its time to maturity, rather than its fugit, would be misled. Covenants referencing such ratios might not "technically" be violated, although economically they might be.

By the way, be careful plugging such bonds into various bond math calculations like OAS - many of them won't even tell you reasonably what the YTM would be if the bond is not called.

The moneyness of the call doesn't change at all when interest rates move. Any OIS-like calculator that assumes that credit spreads won't change, but only risk-free interest rates can move, will just say that the bond will be called with probability 1.