Step-up bonds are really just regular bonds that provide greater flexibility for the issuers. Step-up bonds contain a provision that allows the bond to be called for redemption on set anniversary dates. In exchange for this privilege, the issuer agrees to pay a higher interest rate for each extended period.
Example: A step-up bond may be issued with an initial interest rate of 3.0%, paid annually, and a final maturity in 5 years. The interest rate will increase to 3.50% in the second year, 3.75% in the third year, 4.0% in the fourth year and 4.50% in the fifth and final year. The step-up bond will grant the issuer the option, on each anniversary date, to extend the bond for an additional year. So, if the issuer decides not to extend the bond past its fourth anniversary date, the investor will receive their bond principal, plus accrued interest earned, on the fourth anniversary.
Note: When it comes to redeeming step-up bonds, buyers should be aware that if the issuer decides to redeem the bond prior to the final maturity date, the bonds will be redeemed at the $100 par value. Therefore, investors should be aware of this when looking at a bond's secondary market price, if buying or selling between the issue and maturity dates. Step-up bonds may grant the issuers the right to redeem them at intervals that could be monthly, semi-annually, or annually. A few step-up bond issues do not allow the issuer to redeem the bonds in the first two years after issuance. Investors should read the issues preliminary prospectus closely to fully understand the specific bond features.
When contemplating the purchase of a step-up bond, investors should study the bond’s schedule of interest rates in conjunction with their expectations for future interest rate changes. For example, if a step-up bond has the following 5-year interest rate schedule, 3.0%. 3.25%, 3.50% 4.25% 5.0% and expectations for interest rate levels to not rise in 4 or 5 years, then this would increase the likelihood the issuer will redeem the step-up bond prior to its final maturity date.
In the past step-up bonds were popular with investors when they feared that inflation and interest rates would rise in the future. But as inflation continued to remain subdued and interest rates declined, many investors found the step-up bonds were redeemed prior to the final maturity dates. These early redemptions left investors searching for new bond investments in a lower interest rate environment.
Today step-up bonds are still issued, but they are not as popular with investors due to the unpredictable nature of their maturity. Should inflation begin to rise, however, investors may regain their previous enthusiasm for step-up bonds.