Meaning & Definition
Step-up bonds or step-up notes are securities 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.
Step-up bonds are usually purchased by investors who want to invest in securities similar to Treasury Inflation-Protected Securities (TIPS) but would also want to take advantage of higher interest rates. Thus, we can conclude that step-up bonds have many features similar to Treasury Inflation-Protected Securities (TIPS).
Callable Step-Up Bonds
The issuer of bonds recognizes that the interest rates 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 passing the time, the coupon rate on step-up bonds increases, and if the interest rates 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 of step-up bonds as follows:
Single Step-Up Bonds/Note
When there is only one increase (or step-up) in the bond’s coupon rate over a bond life cycle, such bonds are referred to as 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-up) in the bond’s coupon payments over bond a life cycle, such bonds are referred to as multi-step-up bonds or notes. Our previous example is a multi-step-up bond where 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.
Benefits of Investing in Step-Up Bonds
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 step-up 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 5% coupon rate & a 5 year step-up bond with 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.
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.
Comparatively Liquid Investment
Step-Up bonds are fairly liquid as they are traded 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
As discussed earlier, most step-up bonds come with the callable feature. This means the issuer will force the investors to redeem the bonds during falling interest rates. Thus it can never be surely determined whether investors will get the advantage of higher interest rates or not.
Continue reading – Bonds and their Types.