A step-up bond is simply a bond that has a coupon which increases by specified amounts over time. The coupon on a step-up bond increases at regular intervals until the maturity date. The coupon rates, their rate of increase, and the terms and conditions governing the instrument are established at the point of issuance.

Let’s say an investor purchases a five-year step-up bond from Company A. This step-up bond has a rate of three per cent for the first three years and five per cent for the last two years.

Benefits

A step-up bond provides a fixed stream of income to an investor. This reduces some of the uncertainty inherent in standard variable rate notes and allows the investor to plan his finances for the future with greater accuracy. Essentially, these bonds minimise interest rate risk to the investor over time.

These bonds were very popular at the beginning of the global recession as investors sought to hedge against the decline in economic activity. Step-up bonds are issued by Government agencies as well as private corporations. Weak or just below investment grade corporations issue step-up bonds as a way to encourage investors to purchase their debt in spite of a less than perfect financial position. For example, Anheuser-Busch InBev NV (rated A by S&P), the world’s largest brewer, issued step-up bonds in 2010 with a condition that interest increases by 25 basis points for every one rating notch the company is cut below investment grade, up to a maximum of 200 basis points.

However, US Government Sponsored Enterprises and Federal Government Agencies also issue these instruments to provide investors with more attractive rates of return. This debt is rated AAA by Moody’s and Fitch, and is implicitly backed by the US Government and can provide investors with higher risk adjusted rates of return.

Downside risks

Most step-up bonds have embedded call options. A callable bond gives the bond issuer the right to purchase the bond back from the bond holder before the maturity date. Issuers are more likely to call bonds during periods of low interest rates. This creates an element of reinvestment risk as investors may have to reinvest the proceeds from their redeemed bond at a lower rate.

When to invest in them

Step-up Bonds are particularly attractive in low interest rate environments. The idea is that as interest rates increase so too will the coupon on the bond, but at predetermined intervals. If short-term interest rates do not increase in the near term then the bond continues to offer attractive rates of return and when the step-up occurs.

Opportunity

Step-up bonds issued by US Government agencies are an effective tool which can be used to obtain higher rates of return. The slightly more intricate structure increases the coupon, but on an instrument of investment grade credit quality.

Leverage can be a beneficial tool that can be used to further enhance returns. Let’s say an investor purchases US$100,000 of a five-year step-up bond from Company A. The initial coupon on this bond is three per cent per annum. The investor could borrow up to 80 per cent of the value of the bonds or $80,000 and use $20,000 of his/her equity to purchase $100,000 of the bonds. This allows the investor to earn a return on equity of 11 per cent per annum.

These strategies and instruments can be employed to maximise the return on your investment portfolio. However there are numerous risks that one must consider before pursuing these types of activities. Contact an investment advisor to help you assess the risks and benefits of these instruments.

Dave Cameron is Vice President — Securities Trading at Sterling Asset Management Limited. Sterling provides medium to long-term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net