What is a Step-Up Bond
A step-up bond is a bond that pays an initial coupon rate for the first period, and then a higher coupon rate for the following periods. These bonds are often purchased by individuals or portfolio managers who wish to hold fixed-income securities with similar features to Treasury Inflation-Protected Securities (TIPS) but with a higher coupon. For example, a five-year bond paying a 4% coupon for the first two years and a 6% coupon for the final three years most likely offers a coupon below current rates at the time of inception, compensating the seller for offering higher coupons in coming periods.
BREAKING DOWN Step-Up Bond
Because the coupon payment increases over the life of the bond, a step-up bond lets investors take advantage of the stability of bond payments while benefiting from interest rate increases.
Types of Step-Up Bonds
One type of step-up bond has an increasing coupon payment once during the life of the bond. For example, the coupon payment on a five-year step-up bond is 5% in the first and second years, and then increases to 8% for the remaining three years. With a multi-step bond, the coupon increases multiple times, according to a preset schedule. For example, a multi-step bond pays 3% the first and second years, 4% the third and fourth years, and 5% the fifth year.
Pros and Cons of Step-Up Bonds
Because step-up bond interest payments increase when interest rates rise, investors do not lose out on higher yields. Since the Securities and Exchange Commission (SEC) regulates step-up bonds, only higher-quality corporations or the government, except the U.S. Treasury, may issue step-up bonds, reducing investors’ risk of repayment. In addition, because step-up bonds trade in the secondary market, they are fairly liquid compared to bonds sold only by an issuer.
Since the built-in coupon increases eliminate the uncertainty of future yields with fixed-rate bonds, step-up bonds are less sensitive to market interest rates than regular bonds. This benefits individual investors who dislike price volatility but not institutional investors that may trade on volatility.
However, although coupon increases are built into a step-up bond, receiving the higher rates is not guaranteed. Because most step-up bonds are callable on the step-up date, the issuer may force redemption of the bonds. Also, when interest rates rise more quickly than the predetermined steps, and issuers are unlikely to call the bonds when they are paying below-market rates, investors may be locked into less-advantageous interest rates. Although investors may buy noncallable step-up bonds, the coupon rates may be lower than callable step-up bonds, even though investors are guaranteed higher yields in the future. In addition, when market rates rise, step-up bonds typically trade at a lower price than the investor paid, potentially leading to a capital loss that may offset the investor’s return from the coupon payments. For this reason, step-up bonds are best held to maturity.