Step-Up Bond

A step-up bond is a debt security whose coupon increases during its life. The increase may follow a timetable fixed when the bond is issued, or it may be triggered by an event such as a downgrade of the issuer's credit rating or a failure to meet a stated target. Issuers use step-ups to lower their initial interest cost, to compensate investors for particular risks, or to signal that they intend to redeem the bond before the higher rate applies.

The structure sits between a fixed rate bond, whose coupon never changes, and a floating rate note, whose coupon moves with a market benchmark. In a step-up bond every possible coupon rate is known in advance; only the timing or the trigger determines which applies. The mirror-image structure is the step-down bond.

In the simplest form, the rates and dates are listed in the terms. A five-year note might pay 3 per cent in years one and two, 4 per cent in years three and four, and 5 per cent in the final year. A bond with a single increase is called a one-step note; one with several is a multi-step note.

Most scheduled step-ups are also callable. The issuer has the right to redeem the bond at par on set dates, usually the same dates on which the coupon rises, as laid out in the call schedule. Such notes have long been issued by US government-sponsored agencies and by banks. The investor receives a higher starting yield than on a comparable non-callable bond in return for giving the issuer that option. If market rates stay low, the issuer will redeem before paying the higher coupons; if rates rise, the bond is left outstanding, and the stepped coupons may still be below market levels. The investor is thus exposed to the same reinvestment risk as with any callable bond.

Other step-ups depend on what happens to the issuer:

• Rating triggers. The coupon rises by a set margin if the issuer's credit rating falls below a stated level, and usually falls back if the rating recovers. These clauses became common in European telecommunications bonds around 2000 and remain a feature of some corporate issues.
• Sustainability targets. In sustainability-linked bonds, the coupon typically increases if the issuer misses a specified environmental or social performance target by an observation date.
• Hybrid and perpetual securities. Corporate hybrids and some issues of perpetual bond reset to a higher margin if they are not redeemed at the first call date, which encourages the issuer to call.
• Registration or covenant defaults. Some high-yield bonds pay additional interest if the issuer fails to complete a promised step, such as registering the bonds with the securities regulator.

A rating-triggered step-up protects investors against a fall in the bond's price after a downgrade, but it also raises the issuer's interest bill at the moment its finances are already weakening.

Before the 2008 financial crisis, banks commonly issued subordinated capital instruments with a coupon step-up at the first call date, and investors assumed they would be redeemed then. Regulators concluded that this made supposedly long-term capital behave like short-term debt. Under Basel III, instruments that count as Additional Tier 1 capital or Tier 2 capital may not contain step-ups or other incentives to redeem.

Because the coupons are not level, a single coupon figure says little about return. Investors calculate yield to maturity using every scheduled payment, and for callable notes they also calculate the yield to each call date and take the lowest, known as yield to worst. Pricing a callable step-up requires an option model, since the value of the issuer's right to call depends on the path of future interest rates; this is covered under bond pricing. For event-driven step-ups, the market price reflects the probability that the trigger will occur.

In the issuer's accounts, a scheduled step-up does not mean that interest expense rises in steps. Under the effective interest rate method, the total expected interest is spread over the bond's expected life at a constant rate, so expense is higher than cash paid in the early years and lower later.

Step-up bonds need accurate reference data. Each rate and its start date must be held in the coupon schedule so that accrued interest and payments are calculated at the right rate on either side of a step date. For event-driven bonds, the issuer or its agent announces the change after the trigger, and custodians and data vendors update their records before the next coupon payment. Missed rate changes are a known source of interest claims between counterparties, and the periodic payment itself follows normal bond coupon processing.