One of the main appeals of investing in bonds is that they typically offer fixed interest payments known as coupons. But investors could miss out on the opportunity to earn more money if interest rates rise before the bond reaches maturity. Investing in step-up bonds, which offer gradually increasing coupon payments, can mitigate this risk. Keep reading to find out the advantages and disadvantages of step-up bonds and get the information you need to decide whether step-up bonds deserve a place in your investment portfolio.
Definition and Examples of a Step-up Bond
A step-up bond is a bond that increases its fixed interest payments during its life according to a predetermined schedule. How much the rate will increase—and when—depends on the terms of the bond. For example, the rate may increase during the life of the bond just once or multiple times. The step-up feature offers some protection against interest-rate risk, which is a common concern among bond investors, particularly for fixed-rate bonds. Floating-rate securities can also help mitigate this risk.
Alternate names: Step-up notes, step-ups
When market interest rates rise, bond prices drop. Let’s say you pay a $1,000 bond with a 3% coupon rate. You can expect that bond to generate $30 a year of income until its maturity date. But suppose interest rates rise to 5%. The bond that yields 3% becomes less valuable—provided that all other factors are the same—because $1,000 invested in a newly issued bond could yield 5% per year. But suppose you had a step-up bond that offered 0.5% annual coupon increases. The step-up feature gives you some protection against rising interest rates. After year one, you could earn 3.5%. After year two, you’d receive 4%, and so on. However, there’s no guarantee that step-ups will keep up with market rates.
How Step-up Bonds Work
A company or government may issue step-up bonds hoping to attract investors, particularly if it expects interest rates will soon rise. Doing so allows the issuer to make initial interest payments at lower rates, and then offer a more competitive rate if interest rates rise. A big disadvantage of investing in step-up bonds is that they often have a callable component, which means the issuer can redeem the bonds early by paying investors the face value plus any accrued interest. If this is the case, step-up bonds are disadvantageous to investors when interest rates are falling. A step-up typically becomes callable on each anniversary debt when the coupon resets. It may also become continuously callable during the initial period when the bond can’t be redeemed. Even if interest rates drop or stay the same, an issuer may choose not to redeem its step-up bonds. If the issuer’s credit quality has declined, for example, it may opt to keep its existing debt. Refinancing the debt could be even more expensive than making gradually higher interest payments on step-up bonds.
Pros and Cons of Step-up Bonds
Pros Explained
Protection against interest-rate risk: Rising interest rates are a major concern for bond investors. With step-up bonds, investors are offered some protection against these higher rates. The increasing coupon payment may also provide a safeguard against inflation. Potential for higher rewards: Step-up bonds present the opportunity to earn higher coupons over time. Compared to fixed-coupon bonds with similar maturity dates and credit risks, they generally provided a higher overall weighted coupon average.
Cons Explained
Typically includes a call feature: Most step-up bonds include a call feature, meaning the issuer can redeem the bonds before they reach maturity. This is most likely to happen when interest rates drop because the issuer can refinance its debt at lower rates. A call feature can result in unexpected loss of income for bond investors. Not guaranteed to keep up with interest rates: While step-ups provide some protection against rising interest rates, there’s no guarantee that they’ll keep up with market rates. If interest rates rise rapidly, investors could still miss out on opportunities to earn higher coupons.
