What it means
An ordinary fixed-rate bond pays the same coupon from start to finish. A step-up bond has a built-in ladder, for instance 3% for two years, then 4% for two years, then 5% for the final year.
The schedule is written into the bond terms, so every future payment is known on day one. For investors, the appeal is protection against rising interest rates.
If market rates move up, a standard bond loses value because its coupon looks low, whereas a step-up bond will pay more later. The first coupons are lower than on comparable bonds, so the investor has to wait for the benefit.
Most step-up bonds are callable, meaning the issuer can repay them early at a set price. This is important because the issuer would rather redeem the bond before the higher coupons begin if market rates have not risen.
The investor then receives their money back just when the bond was about to become more valuable. For that reason, investors look at yield to call, the return if the bond is redeemed at the first call date, as well as yield to maturity, the return if held to the end.
The lower of the two is often the more realistic guide. Issuers use step-ups to lower interest costs in the early years, which can help cash flow while a project or business gets established.
Credit risk still applies, because a higher future coupon is only worth something if the issuer survives to pay it. A company that issues a step-up bond may be signalling that it expects to be able to refinance.
Both investors and finance teams should read the call terms carefully.
In practice
Real-world examples.
Example
A retired investor buys $100,000 of a step-up bond starting at 3.5% and rising by 0.5% every two years. She expects interest rates to rise and likes that her income will increase automatically. She understands that the issuer can redeem the bond early if rates stay low.
Example
A utility company issues $300,000,000 of step-up bonds to keep interest costs low while building a new plant. The low early coupons save about $3,000,000 a year in the construction period, compared with a standard bond paying 1% more. The treasurer plans to refinance before the higher coupons begin.
Example
A bank treasury desk compares a step-up bond with a standard bond to decide which suits its liability profile. It notes that the step-up bond yields less in the early years and calculates yield to call and yield to maturity. It buys the standard bond because the early return is more valuable to its funding plan.
Formula
Calculation
Total interest = sum of (face value x coupon rate) for each year
Suppose a $1,000,000 five-year step-up bond pays 3% in years 1 and 2, 4% in years 3 and 4, and 5% in year 5. Interest in years 1 and 2 is 1,000,000 x 3% = $30,000 each year, so $60,000. Interest in years 3 and 4 is 1,000,000 x 4% = $40,000 each year, so $80,000, and year 5 is 1,000,000 x 5% = $50,000. Total interest is 60,000 + 80,000 + 50,000 = $190,000, an average of 190,000 / 5 = $38,000 a year, or 3.8%.Case study
Seen in the real world.
Larkspur Holdings is an illustrative, fictional property company that wanted to borrow $50,000,000 while its new building was being completed. Rental income would not begin for two years, so it chose a step-up bond with a 3% coupon in the first two years and 6% afterwards.
The lower early coupon saved the company $1,500,000 a year compared with a 6% fixed bond during construction. When the building opened, the company refinanced with a conventional loan at 5% and redeemed the step-up bond before the higher coupon applied.
Investors who had bought the bond hoping for a 6% coupon were disappointed. The illustrative lesson is that a step-up feature often comes with a call option, so the final payments may never be received.
Watch out
Common mistakes.
- Judging the bond by its final coupon, when a call feature may mean it is redeemed before that rate is paid.
- Comparing it with other bonds using only the starting coupon, when the average return over its life is what matters.
- Assuming the step-ups protect against all rate rises, when the schedule is fixed and may rise less than the market.
Questions
People also ask.
What is the difference between a step-up bond and a floating-rate bond?
A step-up bond has a fixed schedule of rate increases set in advance, whereas a floating-rate bond resets according to a market reference rate.
Why do issuers sell step-up bonds?
They lower the early interest cost and often keep the right to call the bond before the higher coupons start.
How should I value a step-up bond?
Calculate the yield to call and the yield to maturity and use the lower figure as a cautious guide to the return.
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