Step-Up Bond: Definition, How It Works, Pros & Cons, Example

What Is a Step-Up Bond?

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 increase, 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.

However, the initial rate offered on a step-up bond could be lower than the rates offered in other fixed-income investments. Although there are many benefits to step-up bonds, investors should also be aware of the inherent risks associated with these debt securities.

How Step-Up Bonds Work

Bonds are debt instrument securities or IOUs that corporations and government agencies issue to investors to raise funds for a project or an expansion. Typically, the investor pays for the bond upfront for its face value amount, which could be $1,000 each. The investor would get repaid the $1,000 (called the principal amount), when the bond matures, (called the maturity date). Most bonds pay a periodic interest rate, (called a coupon rate), that's typically fixed over the life of the bond.

For example, if an investor buys a $1,000 Treasury bond with a rate of 2%–maturing in ten years–the investor would be paid interest payments based on the 2% coupon rate. The investor would be repaid the $1,000 principal when the bond matures–or in ten years.

Conversely, a step-up bond pays a lower rate in the early years, and its rate increases over time so that investors receive a higher coupon rate as the maturity date approaches. For example, a five-year 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. 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 increases in the coupon rate. However, as a result of the step-up feature, step-up bonds tend to have lower coupon rates initially, compared to other fixed-rate bonds.

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 can adjust 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 is applied to the adjusted principal amount. As a result, the interest payment amounts rise with inflation and fall with deflation.

Benefits of Step-Up Bonds

Step-up bonds typically perform better than other fixed-rate investments in 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.

It's important to remember that bond prices and interest rates are inversely related, meaning that 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 typically 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.

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.

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.

Step-up bonds are usually issued by high-quality corporations and government agencies, which helps to reduce the risk of default, which is the failure to repay the principal and interest.

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.

Example of a Step-Up Bond

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.