What are Step-up Bonds? Example, Types, Advantages, and Disadvantages

Step-up bonds are variable rate bonds that have a coupon rate that keeps increasing over time. The reason why they are called step-up bonds is due to the interest rate on the bond stepping up over time.

Step-up bonds are advantageous to lenders as it allows them to benefit from increasing interest rates but maybe more disadvantageous to the borrower. Usually, government agencies issue step-up bonds.

Sometimes, the initial coupon rate of step-up bonds may be lower as compared to the interest rate offered on other fixed-income instruments in the market.

Similarly, while there are many advantages of step-up bonds to lenders, there are still some disadvantages that they should understand. These disadvantages arise due to the inherent risks associated with these types of instruments.

Like any other type of bond, step-up bonds also have a face or par value. It is the value of the instrument that investors pay for in cash. Similarly, they also have a coupon rate, which for step-up bonds is usually variable and increases after specific intervals of time.

Bonds also have a maturity date, which is the time when investors get repaid for the face value of the bond. Usually, bonds are fixed-income debt instruments, but step-up bonds are different.

Example

For example, a lender pays buys a fixed-income bond for $1,000 from a company that offers a coupon rate of 4% with a maturity of 5 years.

It means, each year the lender will get an interest payment of $40. After the five years are over, the company will pay back $1,000 to the lender, which is the face value of the bond and the amount the lender paid for originally.

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On the other hand, step-up bonds are different. The lender may receive a lower coupon rate at first, which will increase as the bond ages. For example, a lender pays $1,000 for a step-up bond that offers a coupon rate of 3% initially with maturity after five years.

The coupon rate of 3% only applies to the first two years of the bond after which for the next two years, the coupon rate increases to 4.5%. The coupon rate of the bond increases to 5% in its final year.

It means the lender will receive $30 for each of the first two years, $45 for year two and year three, and finally receive $50 in the last year. The lender will also receive $1,000 on the maturity of the bond, as usual.

Types of Step-Up Bonds

There are two main types of Step-Up bonds that borrowers may issue. These types are single step-up bonds and multiple step-up bonds.

Single Step-Up Bonds

Single step-up bonds are the type of step-up bonds in which there is only a single increase in the coupon rate of the bond, over its life.

For example, a bond with a maturity of 5 years might have a coupon rate of 3% initially, which will increase to 5% after two years and apply throughout the maturity of the bond.

Multiple Step-Up Bonds

Multiple step-up bonds are the type of step-up bonds in which there are several changes in the coupon rate of the bond over its lifecycle.

For example, a bond has a 5-year maturity and might have an initial coupon rate of 3%. The coupon rate will increase to 4% after two years. It will increase even further to 5% for the last year of the bond.

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Advantages of Step-Up Bonds

As previously mentioned, step-up bonds have many advantages for the lender. The first advantage of step-up bonds to lenders is that it allows them to benefit from an increased income as compared to fixed-rate bonds. That means lenders can get higher returns through step-up bonds if they choose them over fixed-income bonds.

For example, if a fixed-income bond offers a coupon rate of 5% while the lender also has a choice to invest in a 5% step-up bond, the step-up bond is the better option.

However, step-up bonds can also be beneficial for the borrower. Most step-up bonds come with a callable feature, using which they can force lenders to redeem the bonds.

Therefore, borrowers can get out of the loan whenever they want to. It can be particularly beneficial for companies that want to raise quick finance by giving lenders an incentive but not allowing the incentive to realize.

Similarly, it allows the borrower to withdraw from the commitment in times of falling interest rates in the market.

Disadvantages of Step-Up Bonds

The advantages mentioned above are also disadvantageous for the other party. For borrowers, they have to pay a higher interest rate as compared to a fixed-income bond.

On the other hand, lenders always face the risk of the borrower calling the shares, thus, not allowing them to benefit from an increase in the rate of the bond.

Conclusion

Step-up bonds are the type of bonds that come with a variable increasing coupon rate. These are better than fixed-income bonds, and allow lenders to get a higher interest on the bond. There are two main types of step-up bonds, single step-up and multiple step-up bonds.

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In a single step-up bond, the coupon rate of the bond increase only once, while in multiple step-up bonds, the coupon rate increases several times over the bond’s lifecycle. Step-up bonds may have advantages and disadvantages for both the lender and the borrower.

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