What is a Step-Up Bond?

Bonds are typically fixed-income instruments. Step-up bonds are a special type of bond that comes with rising interest rates. These bonds offer a low-interest rate initially and then an increased interest rate after a specific period.

It can come with a single interest rate rise or multiple interest rate increases. The interest rates can also be linked with inflation rates. However, the interest rates and their step-up dates are predetermined by the issuer in the beginning.

What is a Step-up Bond?

A step-up bond comes with a lower interest rate initially. Its interest rate steps up after a specific period as described by the issuer.

The interest rate of this bond can increase over specified intervals and up to a specified extent. It can be a single increase in the interest rate and several hikes depending on the terms of the bond. However, the initial interest rate offered on a step-up bond would be lower than other fixed-income instruments.

Bond issuers can take advantage of a lower interest rate environment. The investors can benefit from an increased interest rate in the future that compensates them for lower initial returns.

How Does a Step-up Bond Work?

Like other types of bonds; step-up bonds are issued by corporations and government institutions. The primary objective of these bonds is also to raise capital from the market. For investors, it presents an investment opportunity with additional benefits of increased interest rate at some stage.

Bond issuers can specify different terms with a step-up bond. Hence, it may take several types depending on its characteristics.

Single-Step Bonds

Single-step bonds come with only one interest rate increase over their lifetime. The initial rate and the increased rate are both predefined by the bond issuer.

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Multi-Step Bonds

These types of bonds come with more than one interest rate increase. The interval and each increment in the interest rate are predefined by the bond issuer.

Inflation-Adjusted Bonds

Some step-up bonds can also link the interest rate with the inflation rate. It means the bond interest rate would increase with inflation and decrease with deflation.

These bonds are usually issued in a low-interest rate environment. Bond prices are conversely related to the interest rates offered. However, as bonds are considered fixed-income instruments, lower coupon rates do not attract investors. Hence, the step-up interest rate feature acts as a sweetener for investors.

Example

Let us suppose ABC corporation issues a step-up bond with a single increase feature. The bond is issued with a 10-year maturity period. Suppose the issuer offers an initial interest rate of 3% on the bond.

The issuer can offer a 3% interest rate for the first five years. After that, the issuer can offer an increased interest rate of 5% for the next five years.

The bond can also be issued with a call feature. It means the issuer can call the bond if the interest rate falls instead of rising.

Special Considerations with Step-up Bonds

Step-up bonds can also come with callable and non-callable features as with any other type of bond. As the step-up interest rate feature provides flexibility to the investors, the call feature provides similar flexibility to the bond issuer.

A call feature is usually attached to a bond if the issuer forecasts a fall in the interest rates in the coming years. However, these bonds are less volatile to interest rate changes as they come with an embedded feature of interest rate increment.

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Basically, the bond prices also move in the opposite direction of the interest rates. If the interest rates increase, the value of the bond will decrease. It means the bondholders should hold step-up bonds till maturity to avoid any capital losses. Else, it’s wise to trade the bond before the interest rate hike for higher prices.

Advantages of Step-up Bonds

Step-up bonds offer several advantages to investors and bond issuers.

  • These bonds are regulated by regulatory authorities and are issued by high-quality issuers with credible ratings.
  • The risk of default with these bonds is lower.
  • Investors’ income is protected with increased interest rates.
  • Due to the step-up feature of interest rate, these bonds are less volatile to interest rate risks.
  • Investors can trade these bonds or hold them till maturity.

Disadvantages of Step-up Bonds

Step-up bonds can offer some limitations as well.

  • These bonds are fairly liquid instruments, not as highly liquid as other fixed-income instruments.
  • Issuers often attach the call feature with these bonds that can lower the yield for investors in the long term.
  • Investors can be at a disadvantage even if the interest rates rise above the step-up bond rates.

Conclusion

Step-up bonds come with a flexible feature of changing interest rates. The interest rate of these bonds can increase once or more times as defined by the issuer. These bonds offer flexibility and lower market volatility risks for investors.

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