Step up bonds are often favoured by two or three overall groups of investors:
- Passive investors, who like to park capital in carefully selected investments, for the long term. These investors like to invest and then forget about the investment until maturity; they do not like to have to keep tabs and move capital around. But they do enjoy the reassurance of constant payouts
- Investors who thrive on playing dips and spikes in bond prices, and are looking to diversify the types of securities that they trade.
- Investors hoping to gain the best of both worlds: the security of a fixed income investment and a rate of interest that (potentially) keeps up with – or outpaces – the market.
Additionally institutional investors might of course, have their own strategic reasons for investing in step up bonds.
Whichever group of investors you belong to, you probably want to understand exactly how step up bonds work. If you have read our blog Step Up Bonds, which is a beginner’s guide to this interesting debt security, you are ready to roll up your sleeves and delve deeper into the working of step up bonds. We have a lineup of examples and scenarios to help you wrap your head around the topic.
The proposition
The first thing you need to understand is why step up bonds are popular, and the reason is increasing worth. It’s the same sentiment that pushes people to buy art, precious metals, real estate and stocks – they are drawn in by the possibility that they will one day be able to sell the said investment at a higher price.
Except that in this case, there is a guarantee that the ROI will be consistently increasing in value.
For example, if Priya buys a bond for Rs 10,000 for 10 years and is promised a rate of return of 2.5% at the outset, paid out semiannually rising at 0.5% annually in a total of 4 step ups in the first four years, this is what her earnings will look like:
Year 1: Rs 250 + Rs 250
Year 2: Rs 300 + Rs 300
Year 3: Rs 350 + Rs 350
Year 4: Rs 400 + Rs 400
And then Priya receives that Rs 400 + Rs 400 until maturity.
The calculations
Priya must consider her total earnings on Rs 10,000 worth of capital invested to evaluate the risk reward ratio of the step up bond investment.
She must add up the interest of all the years:
Step 1: Rs 500 in year 1 + Rs 600 in year 2, Rs 700 in year 3 Rs 800 in year 4 = Rs 2,600
Step 2: Rs 800 x 6 years = Rs 4,800
Priya would earn Rs 7,400 by the end of her 10 year investment, meaning that her investment will have appreciated by 74%.
The catch
What can however happen, is that the bond issuer can issue callable bonds that allow for the investors to be paid back early, effectively depriving them of the higher interest rates stage.
If Priya’s bonds are called in the second year, she earns Rs 1100 on her Rs 10,000 investment over 2 years. In other words, in two years, her capital would have appreciated only 11%.
From this illustration of the working of step up bonds, you can see how drastically different the earnings potential can be, depending on whether the bond issuer allows the bond to run to maturity, or calls it early. Put bluntly: The step up rates could just be a suave marketing gimmick.
Combating callability
Investors might want to view the bond issuer’s track record to evaluate the entity’s intention to pay rising interest rates up to maturity. Evaluating the plans that the bond issuer has for the proceeds and their financial track record, might clue investors in to whether they will have the ability to pay rising interest rates.
How investors use/hold step up bonds differently:
Traders
Traders lie in wait for the general flurry of activity and a spike in the step up bond’s price around interest step up dates and will watch for the fall in prices just after the interest is paid out.
They will also observe how market interest rates affect the market price of the step up bond, because when the market interest rates are more attractive than that of the step up bond, the bond will sell at a cheaper price.
The trader will attempt to buy bonds on the troughs after interest is declared, or when the market interest rate rate is higher, so as to avail of a low entry price.
Then, when the price spikes around interest step up time, the trader will attempt to sell the step up bond at a potential profit.
You can expect traders to trade in a high volume of bonds.
Passive investors
Passive investors will buy the bond after a thorough check on the bond issuer’s credentials and will wait patiently for the bond’s maturity, enjoying his appreciating interest payments in the interim.
At times, the interest rate might not keep pace with the market’s interest rates, but the passive investor might simply be seeking a safe investment and sustained income that keeps pace with inflation, rather than competitive returns and aggressive investing with high risk.
Active investors with low risk appetite
The active investor might go for a combination of the above two strategies. They will purchase a step up bond and hold on to it but will keep an eye on the bond issuer’s activities. If they get a hint that the bond issuer plans to call the bond prior to maturity, they might attempt to sell at a potential profit before the bond is redeemed.
Conclusion:
Step up bonds work differently from other bonds because of their increasing interest rates (that make selling them on the stock market a more volatile proposition) and because of the fact that they are callable (that makes them more unpredictable). Invest only if you have the risk appetite and have sufficiently evaluated the opportunity and the bond issuer to your satisfaction.
