What Is a Step-Up Bond?

Step-up bonds are investment securities that pay an initial interest rate but also have a feature where set rate increases happen 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 Bond Coupon Rates

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.

However, it is important to monitor bond prices and interest rates since they are inversely related to each other. When interest rates fall, bond prices increase. Conversely, rising interest rates tend to lead to a sell-off in the bond market, and bond prices fall. The reason for the sell-off is that existing fixed-rate bonds are less attractive in a rising rate market. Investors demand higher-yielding bonds as rates rise and dump their lower-rate bonds. Step-up bonds help investors avoid this process since the rate of the bond increases over time.

Key Takeaways

  • A step-up bond is a bond that pays a lower initial interest rate but includes a feature that allows for rate increases at periodic intervals.
  • The number and extent of the rate increases, as well as the timing, 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, while others may have multi-step increases.

Step-Up Bond Rate Increases

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. Step-up bonds are issued by the U.S. Treasury and large corporations have a low risk of default or failure to pay back the investor.

Benefits of Step-Up Bonds

Step-up bonds typically perform better than other fixed-rate investment is a rising rate market. With each step, bondholders are paid a higher rate, and since there's less risk of losing out on higher market rates, step-ups have less price volatility or price fluctuations.

Step-up bonds sell on the secondary market and are regulated by the Securities and Exchange Commission (SEC). As a result, there are usually enough buyers and sellers in the market called liquidity allowing investors to enter and exit positions with ease.

Pros

  • Step-up bonds increase interest payments within the life of the bond.

  • The Securities and Exchange Commission regulates step-up bonds.

  • Only high-quality corporations and the U.S. Treasury may issue step-up bonds.

  • The step-up provision reduces the exposure to market rate moves and price volatility.

  • Step-up bonds sell on the secondary market allowing them to remain liquid.

Cons

  • Higher rates are not guaranteed as many step-up bonds are callable.

  • If market rates rise more than the step-up increases, the bondholder faces interest rate risk.

  • Noncallable step-ups pay lower coupon rates since there's no fear of early redemption.

  • Step-ups sold early could incur a loss if the sale price is less than the purchase price.

Risks of Step-Up Bonds

On the downside, some step-up bonds are callable, meaning the issuer can redeem the bond. The callable feature will be triggered when it benefits the issuer meaning if 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 at the same rate received from the step-up bond. Also, if the investor purchases a new bond, the price will likely be different from the original purchase price of the step-up bond.

Although step-up bonds increase at set intervals in a rising-rate environment, they can still miss out on higher interest rates. If market rates are rising at a faster rate than the step-up increases, the bondholder will experience interest rate risk. Also, the investor may have an opportunity cost and reinvestment risk if the step-up bond is paying a lower-than-market rate versus other bonds available.

Bond prices fluctuate periodically. If a step-up bond is sold before its maturity date, the price the investor receives could be lower than the original purchase price leading to a loss. The investor is only guaranteed the principal amount being returned if the bond is held to maturity.

Real World Example

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.