What Is a Step-Up Bond
Step-up bonds are investment securities that pay an initial interest rate but has a feature whereby set rate increases occur at periodic intervals. The number and extent of the rate increases, as well as the timing of the hikes, depends on the terms of the bond. A step-up bond provides investors with the benefits of fixed-income securities while keeping up with rising interest rates.
Step-Up Bonds Explained
Because the coupon payment increases over the life of the bond, a step-up bond lets investors take advantage of the stability of bond interest payments while benefiting from interest rate increases. As an example, a step-up bond might have an initial rate of 2.5% for the first two years and a 4.5% coupon rate for the final three years.
Step-up bonds tend to have lower coupon rates or interest rates initially since they have the step-up feature. However, investors might still come out ahead as compared to other fixed-rate securities, if interest rates rise since the step-up bond has the rate increase feature.
- A step-up bond is a bond that pays a lower initial interest rate but has a feature whereby set rate increases occur at periodic intervals.
- The number and extent of the rate increases, as well as the timing of those increases, depends on the terms of the bond.
- A step-up bond provides investors with the benefits of fixed-income securities while keeping up with rising interest rates.
- Some bonds are single step-up bonds that have only one increase in the coupon rate during the bond's life while others may have multi-step increases.
Types of Step-Up Bonds
The structure of step-up bonds can have either single or multiple rate increases. Single step-up bonds, also known as one-step bonds, have one increase in the coupon rate during the life of the bond. Conversely, the multi-step-up bond adjusts the coupon upward several times within the life of the security. The coupon increases follow a predetermined schedule.
Step-up bonds are similar to Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS increases with inflation and decreases with deflation. Inflation is the rate of price increases in the U.S. economy and is measured by the Consumer Price Index. TIPS pay interest semiannually, at a fixed rate, which also rises with inflation and falls with deflation.
Pros and Cons of Step-Up Bonds
As with most things in life, there are both advantages and disadvantages to owning a step-up bond. Investors in this fixed-income security predict that market interest rates will increase during the life of the bond. Since the rate of the bond's coupon also increases they won't lose out on higher yields.
Investors don't lose out on higher yields, or rising rates since step-up bond interest payments increase over time
The Securities and Exchange Commission (SEC) regulates step-up bonds giving them a lower risk of default.
Only high-quality corporations and the U.S. Treasury may issue step-up bonds.
The step-up provision reduces the bond's exposure to market rate increases providing less volatility.
Step-up bonds sell on the secondary market allowing them to remain liquid.
Higher rates are not guaranteed as most step-up bonds are callable.
If market rates rise more than the step-up increases the bondholder experiences opportunity cost and reinvestment risks.
Callable bonds benefit the issuing company who won't recall the security when the bond pays a rate lower than market rates.
Noncallable step-up bonds offer lower coupon rates since they remove the fear of early redemption.
Step-up bonds could trade on the secondary market at a lower price than what the investor paid leading to a capital loss if sold.
On the downside, should market rates fall, the investor has a chance of the bond's issuer calling back the security. If the bond is recalled, it will be unlikely that the investor will be able to reinvest his returned principal at the higher rate they were receiving from the step-up bond.
Real World Example of a Step-Up Bond
Let's say Apple Inc. (AAPL) offers investors a step-up bond with a five-year maturity. The coupon rate or interest rate is 3% for the first two years and steps up to 4.5% in the following three years.
Shortly after purchasing the bond, let's say overall interest rates rise to 3.5% in the economy after the first year. The step-up bond would have a lower rate of return at 3% versus the overall market.
In year three, interest rates fall to 2.4% due to the Federal Reserve signaling it'll keep market interest rates low to boost the economy for the next few years. The step-up bond would have a higher rate at 4.5% versus the overall market or typical fixed-income securities.
However, if interest rates rose during the life of the step-up bond and consistently exceeded the coupon rate, the bond's return would be lower relative to the overall market.