If you’re someone investing in bonds, you’re probably doing it because you are risk-averse; you value stable cash flows over capital appreciation, and you would much rather conserve your money against inflation than risk it for real gains.
Step-up bonds, in that case, are an even better investment because with them, not only do you get increasing cash flows over time, you do so at the exact same amount of risk.
In this article, we’re going to explore what step-up bonds are, and understand their risks and advantages to investors.
Understanding step-up bonds
Step-up bonds are not very different from regular bonds. They also require you to lend money to another entity for a fixed amount of time, receive fixed interest (coupon) payments as your return on capital, and make your principal back at the end of the whole thing.
The only thing that changes for step-up bonds is the interest rate. The rates, when you buy the bond, are exceptionally low, but go on increasing as time passes. The issuer makes the commitment to notch up the interest rates at regular intervals, resulting in greater cash flows for you.
When buying the bond, the issuer will specify the following for you:
- The frequency of the step up in interest rates
- The rate or rate range of step up in interest rates
- The number of step up rates increases until the maturity date
- The timing and dates for the step-up
Calculating the return on a step-up bond
The return on a step-up bond can be calculated in the same manner as any other bond valuation. You start by calculating the amount of cash you’d be generating at every regular interval, and then discount those cash flows at a certain discount rate.
For instance, if the risk-free rate in the economy sits at 5%, you have to ensure that you are making at least 5% from your bond investment. Otherwise, you are theoretically losing money.
Investing in step-up bonds: Pros and cons
Pros
Here are some benefits of buying step-up bonds:
- Protection against rising interest rates – Rising interest rates are a real problem for bond investors. As rates rise, bond valuations go down, which means that if you want to sell your bond, you get back less than what you paid for it. Step-up bonds, on the other hand, protect you against rate hikes because they have hikes inbuilt.
- Enhanced predictability – Since the terms of the step-up are decided when you buy the bond itself, you know exactly what your cash flows look like throughout the term of the bond.
- Competitive yields in later years – As time goes by, your cash flows increase if you keep the bond till maturity.
- Reduced reinvestment risk – While you might need to reinvest your coupons in a traditional bond at competitive rates to get a step-up in returns, step-up bonds incorporate this on their own, thereby reducing your reinvestment risk.
Cons
- Low initial yields – For the step-up to be worth it to the issuer, starting interest rates are low. This means that you could lose money if you hold the bond for a long time.
- Call features – Step-up bonds are callable, which means that your principal could be returned to you at lower rates at the discretion of the issuer.
- More complex than regular bonds – Harder to understand, value, and sometimes discount.
Step-up bonds in real life
The Indian bond market has also witnessed a growing presence of step-up bonds in recent years.
A prominent example is the HUDCO Series 46B Step-Up Bond Issue raised in 2022. This bond offered an initial coupon rate of 5.60%, with guaranteed step-ups of 0.25% every year until maturity in 2032. This translates to a final coupon rate of 7.60%, significantly higher than the initial rate and providing investors with a hedge against potential interest rate hikes.
Frequently Asked Questions
Not necessarily. While their rising interest rates offer protection in high interest-rate environments, the lower initial yield might not appeal to investors seeking immediate high returns. Additionally, understanding the call features and step-up schedule requires a good understanding of bond fundamentals. These bonds are ideal for long-term, risk-averse investors confident in rising interest rates.
Analysing the “yield to maturity” parameter is crucial. This factors in both the coupon payments and the bond’s price at maturity. For step-up bonds, consider the average yield over the entire holding period instead of just the initial rate. Then, compare this average yield to the yield to maturity of the regular bond.
While this is unlikely, if rates unexpectedly fall, the step-up feature still applies. Your bond’s value, however, might decline due to the higher prevailing interest rates in the market. However, you’ll still benefit from the increasing coupon payments, offering some protection against value erosion.
Yes, step-up bonds can be traded on secondary markets like regular bonds. However, the price depends on current market interest rates and remaining step-ups. If rates have risen, you might fetch a higher price due to the bond’s attractive future returns. Conversely, falling rates could lower the price.
Financial news websites, brokerage firms, and bond market data providers like Bloomberg or Reuters regularly list available step-up bonds.