Why Step-Up Bonds?

Meaning

Step-up bonds or notes are a type of bond with a coupon rate that increases over time. These securities are called step-up bonds because the coupon rate “steps up” over time. For example, the step-up bond could have a 5% coupon rate for the first two years, 5.5% for the third and fourth years, and 6% for the fifth year.

Why do People Buy Step-up Bonds?

Investors usually purchase step-up bonds as they want to invest in securities similar to Treasury Inflation-Protected Securities (TIPS) and also want to take advantage of higher interest rates. Thus, we can conclude that these bonds have many features similar to Treasury Inflation-Protected Securities (TIPS).

Why do Company Issue Step-up Bonds?

Companies issue bonds in order to raise finance. But many may have a question that why the company is willing pay more interest by issuing such type of bonds when it can raise funds by issuing normal bonds too. The only reason is to attract investors. Since there is risk of high interest payment, these bonds also come with a feature of callability.

step up bonds

Callable Step-Up Bonds

The issuer of bonds recognizes that the interest rates in the market may fall below the bond’s coupon rate at some time in the future. Thus redeeming these high coupon-rate bonds & replacing them with low coupon-rate bonds will be beneficial cost-wise. This is especially applicable for step-up bonds as, with the passing of time, the coupon rate on these bonds increases, and if the interest rates in the market fall, it would be a loss to issuers. For this reason, most step-up bonds come with a callable feature. This means when the interest rates fall; the issuers use the callable feature to call back (redeem) the step-up bonds to avoid future losses.

Types of Step-Up Bonds

There are mainly two types which are as follows:

Single Step-Up Bonds/Note

When there is only one increase (or step-up) in the coupon rate over a bond life cycle, we call such bonds single step-up bonds or notes. For example, a 5-year step-up bond might have a coupon rate that is 5% for the first two years & then increases to 6% for the last 3 years.

Multiple Step-Up Bonds/Note

When there is more than one change (or multiple step-ups) in the coupon payments over the bond’s life cycle, such bonds are multi-step-up bonds or notes. Taking into account the previous example, it can be a multi-step-up bond where the bond could have a 5% coupon rate for the first two years, 5.5% for the third and fourth years, and 6% for the fifth year.

Benefits

There are many benefits of investing in step-up bonds as follows:

Higher Coupon Payments and Higher Yields

When the interest rates rise, the coupon payment of these bonds also increases. This results in higher yields for the investors, which might not be possible in fixed coupon bonds. For example, an investor has two types of bonds, a 5-year U.S. Treasury bill with a 5% coupon rate & a 5-year step-up bond with a 5% coupon rate in the first two years and 6% in the next three years. If, after two years, the interest rate in the market increase to 6%, the investor is actually at a disadvantage by investing in 5 year U.S. Treasury bill as he only gets a 5% coupon payment. On the other hand, the step-up bond keeps up with the market and pays a 6% coupon payment to the investor.

High-quality Issuers

The issuers of step-up bonds are monitored and governed by the Securities and Exchange Commission. Because of this, only high-quality creditworthy entities may be able to issue these bonds. This reduces the default risk for investors.

Also Read: Callable Bonds

Comparatively Liquid Investment

Step-Up bonds are fairly liquid as they trade in a primary and a secondary market. An investor can convert his bond into cash as per his convenience and liquidity requirements. Because of such a liquid market, the investors will also get the best prices for their investments.

Risks of Investing in Step-Up Bonds

Forced Redemption

As discussed earlier, most of these bonds come with the callable feature. This means the issuer will force the investors to redeem the bonds during falling interest rates. Thus it is hard to determine whether investors will get the advantage of higher interest rates or not.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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