Step Up Bonds: Pros and Cons

Step-up bonds are special types of fixed income instruments. They help investors partially offset the risks of rising interest rates. This is because when investors invest in a bond, they typically lock in an interest rate. If the interest rate rises beyond that number, then the investors are at a loss because their money has been locked up at a lower rate. This is not the case with step-up bonds where the interest rates rise according to a predetermined schedule.

Step-up bonds can also be of multiple types. For instance, step-up bonds can either be single-level step-up bonds or multi-level step-up bonds. The interest rates of single-level step up bonds reset only once during the lifetime of the bond whereas multi-level step up bonds reset several times.

In this article, we will understand the pros and cons of investing using step-up bonds.

Pros of Step-Up Bonds

Step-up bonds are popular because they provide several distinct advantages to investors. Some of these advantages are mentioned below:

  • Higher Yields: Step-up bonds are designed to provide guaranteed higher yields to investors. The bonds are created in such a way that the coupon payments in the last few years of the existence of the bonds are much larger than the expected interest rate during the same period. This is what makes step-up bonds a lucrative proposition for investors who do not mind taking the additional risk in order to earn the extra yield.

  • Longer Investments: Since step-up bonds are created in a manner that higher interest rates are paid in the end, investors are incentivized to hold onto the bonds for longer periods of time. This creates an incentive to hold on to the bonds for long periods of time. As a result, there is less volatility in the market price of step-up bonds.

  • Less Sensitive to Interest Rates: Step-up bonds tend to have their own interest rate schedule. This schedule is designed in such a way that the rates rise either once or multiple times during the tenure of the bond. However, since the interest rates applicable to this bond are completely unrelated to the interest rate prevailing in the market, such bonds have lesser interest rate risks. This means that changes in the interest rates generally lead to significant fluctuations in the price of the bonds. However, they do not lead to severe fluctuations in the prices of step-up bonds.

  • Regulated: Lastly, since step-up bonds can also be risky, regulatory bodies all over the world tend to pay special attention to such bonds. As a result, step-up bonds are only issued by reliable companies with strong balance sheets. This is the reason that step-up bonds have a lower rate of default as compared to overall bonds in the market.

Cons of Step-Up Bonds

Step-up bonds also have some significant disadvantages. Details of these disadvantages have been mentioned below:

  • Callable: Firstly, a lot of step-up bonds are callable. This means that most companies only give investors an illusion that they will be paid interest rates that are above market rates. However, if such a situation actually arises and the coupon rates are actually higher than the prevailing interest rates, it is quite likely that the company will simply call the bonds. This is the reason that many investors believe that step-up bonds are only a marketing gimmick.

    It is true that step-up bonds can also be non-callable which would make the interest commitments legally binding for the company regardless of general market conditions. However, non-callable step-up bonds are rare since most companies are averse to giving such commitments.

  • Less Liquid: As mentioned above, step-up bonds are generally held by investors for the long term. The reason behind this is quite simple. Interest rates, as well as bond values, are inversely related. Hence, whenever interest rates rise, the bond values will immediately go down. As a result, the extra coupon which may be gained by selling the bond and reinvesting the proceeds may be lost upfront as the value of the bond goes down in value. As a result, investors do not have any incentive to trade such bonds. They are generally held to maturity. For an investor, this could spell trouble. This is because it could mean that there is no active market for such bonds. Hence liquidating such bonds can be a time-consuming and expensive affair.

  • Interest Rate is Not Market Linked: It also needs to be understood that the interest rates which are offered by step-up bonds work on their own schedule. As a result, the interest rate offered is fixed beforehand. It is not actually linked to the market interest prevailing at that point in time. This ends up having a significant impact on the valuation of the bond. The reason behind this impact is that even if the market interest rates go higher than the step-up rate, investors have no recourse. They cannot actually sell the bonds since the valuation of the bonds would have been adjusted by the market.

The bottom line is that step-up bonds serve a very specific purpose. They work well only for certain types of investors who have specific needs. This is the reason that these types of bonds are very popular amongst certain investor communities whereas they aren’t popular with others.

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