Step-Up Bond

What Is a Step-Up Bond?

A step-up bond is a bond that pays a lower initial interest rate however incorporates a feature that allows for rate increases at periodic stretches. The number and degree of the rate increase, as well as the timing, relies upon the terms of the bond. A step-up bond furnishes investors with the benefits of fixed-income securities while keeping up with rising interest rates.

In any case, the initial rate offered on a step-up bond could be lower than the rates offered in other fixed-income investments. In spite of the fact that there are many benefits to step-up bonds, investors ought to likewise know about 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. Commonly, 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 develops, (called the maturity date). Most bonds pay a periodic interest rate, (called a coupon rate), that is ordinarily fixed over the life of the bond.

For instance, in the event that an investor purchases a $1,000 Treasury bond with a rate of 2%-developing in decade the investor would be paid interest payments in view of the 2% coupon rate. The investor would be repaid the $1,000 principal when the bond develops or in decade.

On the other hand, a step-up bond pays a lower rate in the early years, and its rate increases after some time with the goal that investors receive a higher coupon rate as the maturity date draws near. For instance, a five-year step-up bond could have an initial rate of 2.5% for the initial two years and a 4.5% coupon rate for the last three years. Since the coupon payment increases over the life of the bond, a step-up bond allows investors to exploit the stability of bond interest payments while profiting from increases in the coupon rate. In any case, because of the step-up feature, step-up bonds will generally 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 different rate increases. Single step-up bonds, otherwise called one-step bonds, have one increase in the coupon rate during the life of the bond. On the other hand, the multi-step-up bond can change the coupon upward several times inside the life of the security. The coupon increases follow a foreordained schedule.

Step-up bonds are like Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS increases with inflation and diminishes with deflation. Inflation is the rate of price increases in the U.S. economy and is estimated by the Consumer Price Index. TIPS pay interest semiannually, at a fixed rate, which is applied to the adjusted principal amount. Thus, the interest payment amounts rise with inflation and fall with deflation.

Benefits of Step-Up Bonds

Step-up bonds regularly 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 vacillations.

It's memorable's important that bond prices and interest rates are conversely related, implying that when interest rates fall, bond prices increase. On the other hand, rising interest rates will quite often lead to a sell-off in the bond market, and bond prices fall. The justification behind the sell-off is that existing fixed-rate bonds are less appealing in a rising-rate market. Investors commonly demand higher-yielding bonds as rates rise and dump their lower-rate bonds. Step-up bonds assist investors with staying away from this interaction since the rate of the bond increases over the long run.

Step-up bonds sell on the secondary market and are regulated by the Securities and Exchange Commission (SEC). Subsequently, there are typically an adequate number of purchasers and sellers in the market-called liquidity- allowing investors to enter and exit positions easily.

On the downside, some step-up bonds are callable, meaning the issuer can recover the bond. The callable feature will be set off when it benefits the issuer meaning in the event that market rates fall, the investor gets an opportunity of the bond's issuer calling back the security. Assuming the bond is recalled, it will be improbable that the investor will actually want to reinvest at a similar rate received from the step-up bond. Likewise, on the off chance that the investor purchases another bond, the price will probably be unique in relation to the original purchase price of the step-up bond.

Despite the fact that step-up bonds increase at set spans in a rising-rate environment, they can in any case pass up higher interest rates. On the off chance that market rates are rising at a quicker rate than the step-up increases, the bondholder will experience interest rate risk. Likewise, the investor might have an opportunity cost and reinvestment risk on the off chance that the step-up bond is paying a lower-than-market rate versus different bonds available.

Step-up bonds are normally issued by excellent corporations and government agencies, which assists with lessening the risk of default, which is the inability to repay the principal and interest.

Bond prices change periodically. On the off chance that 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 possibly guaranteed the principal amount being returned assuming the bond is held to maturity.

Illustration of a Step-Up Bond

Suppose Apple Inc. (AAPL) offers investors a step-up bond with a five-year maturity. The coupon rate or interest rate is 3% for the initial two years and steps up to 4.5% in the following three years.

Soon after purchasing the bond, suppose overall interest rates rise to 3.5% in the economy after the principal 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 support the economy for the next couple of years. The step-up bond would have a higher rate at 4.5% versus the overall market or regular fixed-income securities.

In any case, assuming that interest rates increased during the life of the step-up bond and reliably surpassed the coupon rate, the bond's return would be lower relative to the overall market.

Features

• A step-up bond is a bond that pays a lower initial interest rate however incorporates a feature that allows for rate increases at periodic stretches.
• The number and degree of rate increases-as well as the timing-relies upon the terms of the bond.
• A few bonds are single step-up bonds that have just a single increase in the coupon rate, while others might have multi-step increases.
• Step-up bonds furnish investors with periodic interest payments while allowing them the chance to earn a higher rate from here on out.