At the most basic level, step-up bonds have coupon payments that increase (“step-up”) over the life of the security according to a predetermined schedule. In most cases, step-ups become callable by the issuer on each anniversary date that the coupon resets or continuously after an initial non-call period. There are several variations of this type of bond but typically they fall into one of two categories: one-step bonds, in which the coupon will reset once during the life of the bond; or multi-step bonds, where the coupon will reset multiple times.
Issuers of these bonds range from Government Sponsored Enterprises (GSEs) to well-known corporations.
Fixed income investors have the freedom of choosing the frequency of payments, the current cash flows as well as type of payments such as fixed over the life of the bonds, variable that usually reflect changes in a specific benchmark or (3) ones that change cash flow based on a predetermined schedule, also known as step-up securities. Step-ups attract investors as they generally provide a greater overall weighted average coupon than comparable fixed-rate investments. The relative value of a step-up bond will depend on the intended holding period, the coupon on the bond and the investor’s expectation of future interest rates. As with any callable bond, the price of a step-up bond is determined by the credit risk of the issuer, the prevailing level of interest rates and the value of the embedded call option.
Even though the initial coupon paid on a step-up is usually lower than the rates of comparable fixed-rate investments, the step-up may eventually increase its coupon payments. In effect, the step-up investor chooses to forgo some interest income in the near-term in exchange for the potential of receiving a higher yield over the life of the investment. The risk, however, is that as the coupon rate on a step-up bond rises over comparable rates, the bond is more likely to be called by the issuer and the investor will not receive these higher coupon payments. Additionally, as the future coupons on step-ups may reset to higher levels than those of comparable fixed-rate securities, there is also a greater likelihood of a step-up being called. This may expose the investor to reinvestment risk, as the principal will most likely be returned during a lower interest rate environment. As compensation for the right to redeem the bond early, the issuer will provide the investor with a higher coupon rate than would typically be available for a similar non-callable security. On the other hand, an investor is also exposed to risk that the scheduled coupon increases may not keep up with prevailing interest rates. Consequently, this type of bond’s expected rate of return as well as maturity may be affected.
If liquidity is desired in the secondary market, premiums on step-up prices will be bounded by the price to the first call date. On the downside, the gradual increase in the coupon, assuming the bonds are not called, may partially protect the investor from price erosion. However, if interest rates jump drastically, the chance of a call will be reduced and the investor may end up holding a bond with a lower coupon than others currently available in the market, and therefore a lower price.
The shape of the yield curve indicates the market’s perception of future interest rates. Generally speaking, a flattening of the yield curve assumes a rise in short-term rates, and consequently, an increase in the expected final maturity of the step-up bond. Conversely, a steepening of the yield curve assumes a rise in longer-term rates, a decrease in short-term rates and therefore shortens the expected final maturity. In other words, step-up bonds have a higher likelihood of being called the higher the coupon rate and closer the bond is to maturity.
Let’s illustrate the unique characteristics of step-up bonds. The table below details an example 10-year step-up bond with yearly call dates and coupon “step-ups”. In this example, the coupon rate increases by 50 bps each year if the issuer does not call the bond on the stated call date. If the issuer chooses to call the bond, the investor will receive par value. In this example, the 1-year corporate rate in the 7th year would have to be higher than 6% for the bond not to be called by the issuer.
(This is a hypothetical example for illustrative purposes only. It is not intended to reflect the actual performance of any security. Investments involve risk and you may incur a profit or a loss.)
Step-up bonds are most suitable for investors who believe rates will go up in the future and who would like a possibility of an increasing stream of income. Attractive yields and incremental “stepping-up” of the coupon, combined with an intermediate maturity, provide an investor with a unique approach to potentially protect principal from inflationary pressures. On the other hand, should rates rise quickly, there is a potential erosion of principal as bonds increase in duration since the scheduled coupons may not keep up with interest rate increases over a longer holding period. Should rates stay the same or even go down further, the potential increases for a call– especially as the bonds get closer to maturity and may have very high coupon resets.
For those investors that do not have this type of flexibility, non-callable bonds, or fixed coupon bonds, assure the investor of predictable cash flows for a definite period of time.