Step-Up Bonds Definition & Downside Risks

What is a Step-Up Bond

A step-up bond is a type of variable note.  The step-up bonds coupon increases at regular intervals until the bond reaches its full maturity.  These higher rates are predetermined when the bond is initially purchased.  The benefit of this type of bond is that an investor does not have to concern themselves with how the price will fluctuate relative to the market index, since the higher coupon rate is fixed.  Step-up bonds are generally issued by government agencies. 

Example of  a Step-Up Bond

Let's say an investor purchases a 5-year step-up bond from Company A.  This step-up bond has a rate of 3% for the first three years and 5% for the last two years.  The benefit of the step-up bond is that the investor will usually receive the initial coupon above the market and will know exactly what to expect from their bond over the long-term.

Downside of Step-Up Bonds

While step-up bonds have the allure of the increasing return over time, the downside is that the bonds are callable by the issuer.  So, if interest rates fall to 3% but the step-up bond rate is 7%, the issuer will recall the bond and issue it at the lower rate in order to reduce the cost of borrowing.