A step-up bond is a bond which pays interest at a rate which improves over the life of the bond. This improvement is determined at the outset of the bond agreement and allows the investor to see increased returns as the bond is held over time. The main benefit of a step-up bond, which can be issued by government agencies or private corporations, is that it protects the investment from rising interest rates by having rate hikes already built into it. It is important to note, however, that these bonds are generally callable, meaning that the issuers may purchase them back from investors at their discretion.
Bonds are generally issued by institutions to investors as a method of raising funds. An investor buying a bond pays a principal amount in return for regular interest payments at a predetermined coupon rate along with the eventual return of the principal once the bond reaches its maturity. Rising interest rates in the bond market can damage the returns of normal bonds, which have coupon rates set in stone that may not stay competitive. One way for an investor to avoid this fate is to purchase a step-up bond.
The distinguishing characteristic of a step-up bond is that its coupon rate rises over the course of the bond's life. For example, a bond with a duration of five years might have a five percent coupon for its first two years. At that point, it steps up to seven percent for the remaining three years. Some step-up bonds may have multiple step-ups in the duration of the bond.
In this way, a step-up bond can help an investor keep up with rising interest rates that can potentially occur in the market. There are other benefits to these bonds, including the fact that they have excellent liquidity, meaning that they can be bought and sold easily. Government agencies are the main issuers of these bonds, although some corporations may use them as a means of attracting investors who may otherwise be leery about poor credit ratings attached to these corporations.
When an investor purchases a step-up bond, the main risk that he or she incurs is the possibility that the issuer will call the bonds back from investors at any point. This will usually occur if prevailing interest rates drop, since the issuer knows that it can refinance its debt at more favorable conditions. For that reason, investors in these bonds must try to anticipate interest rate movements to ensure that the bonds will reach their potential.