When interest rates are low or rising, investors may be reluctant to invest in bonds because they don't want to miss out on higher future rates. Step-up bonds allow you to take advantage of the stability of bond payments and benefit from interest rate rises because the coupon or interest payment increases over the life of the bond. Even better, if rates fall, your coupon payment will still increase.
How They Work
There are two types of step-up bonds. One-step bonds have their coupon payment stepped up once during the life of the bond. For example, the coupon payment on a five-year bond may be 5 percent in the first and second years, then go to 8 percent for the last three years. With multi-step bonds, the coupon is increased several times according to a predetermined schedule. Step-ups are issued both by corporations and by government agencies; the United States Treasury does not offer a step-up bond.
Your bond interest payments increase when interest rates rise, which means you don't lose out on higher yields. Step-ups can be offered by higher-quality issuers only; as with all bonds, the Securities and Exchange Commission regulates step-ups and the companies which issue them. These bonds trade on the secondary market, where you can buy from or sell from other investors, just like stocks, so they are fairly liquid compared to bonds which are sold only by the issuer.
While coupon increases are built into the bond, there are no guarantees you ever get the higher rates. Most step-up bonds are callable on the step-up date, meaning the issuer can force you to redeem the bond. Issuers are unlikely to let the coupon rise above market rates. If interest rates rise more quickly than the predetermined steps, you can be locked into a disadvantageous rate because the issuer won't call them as long as they pay below-market rates. Though they are less prevalent, you can buy non-callable step-up bonds to avoid this risk; though the coupon rates may be slightly lower than callable step-ups, you are assured of the higher yields later on.
Remember that when interest rates rise, the price of bonds falls. Because of the existence of a secondary market for step-up bonds, when market rates rise they may trade at a lower price than you paid, leading to a capital loss that might offset your return from the coupon payments. For this reason, step-up bonds are best held until maturity. Step-ups are less sensitive than regular bonds to market interest rates because of the built-in coupon increases which eliminate the uncertainty of future yields with fixed-rate bonds. This is a plus for individual investors who tend to dislike price volatility, but a drawback for institutional investors who may trade on volatility.
Market-Linked step-up bonds differ from typical step-up bonds in that they are structured investments that tie the return to that of the stock market to offer investors a way to lock in specific returns. Generally offered by a bank, they are not liquid, since there is no secondary market, and they have higher fees and administrative costs than the market indexes they are tied to, which means your actual return is lower than investing in the index.
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