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Step-Up Bond

Reviewed by Bhavana | Updated on Sep 30, 2020

Catalogue

Introduction

A step-up bond provides the benefits of fixed-income securities to investors while keeping up with rising interest rates. They are often issued by government agencies. You can think of step-up bonds as investment securities that pay an initial interest rate; they also have a feature where the set rate increases at regular intervals. The extent of the rate increase, the frequency, and the timing of the hike depends on the terms of the bond.

A step-up bond is a security that has a coupon rate which increases with time. A step-up bond typically performs better than any other fixed-rate investment in a rising rate market. The Securities and Exchange Commission (SEC) regulates the step-up bonds.

Step-up bonds tend to have lower coupon rates or interest rates initially since they have the step-up feature. However, investors might still show more interest as compared to other fixed-rate securities as the step-up bond has the rate increase feature.

The commitment of providing higher future coupon payments is a way for investors to earn increasingly higher yields on their holdings. Since most step-up bonds are callable in nature, the returns can be difficult to figure out, i.e. the high rates promised in later years will not materialize if the issuer calls the bonds.

Understanding Step-Up Bond

Callable step-ups have more call risk than traditional callable bonds because issuers of step-up bonds often call their bonds even if interest rates stay flat. On the other hand, issuers of traditional callable bonds don't call their bonds unless rates go up. Investors can count on their step-up bonds being called unless interest rates rise higher than the coupon rate on those bonds.

You must know the following about step-up bond:

  1. A step-up bond can provide increasing income streams and higher coupons versus fixed coupon alternatives.
  2. A step-up bond has the potential to render higher returns against comparable non-callable securities.
  3. In case step-up bonds are sold before maturity, the price an investor receives could be lesser than the actual purchase price.
  4. The structure of a step-up bond can either have a single rate increase or can have multiple rate increases.

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