You know those songs that you need to start singing an octave lower than you normally sing because otherwise, your voice will crack by the time you reach the highest notes in the song; So you start then out in a real bass voice?
Step up bonds work in somewhat the same manner. They have purposefully low interest rates at the outset, because of the commitment to notch up – or step up – interest rates at regular intervals.
The bond issuer will specify:
- The frequency of the step up in interest rates
- The rate or rate range of step up in interest rates
- The number of step up rates increases until the maturity date
- The timing and dates that one might expect the hikes to happen
The bondholder should calculate how much the interest rates are likely to increase and what this translates to in terms of return on investment. Then, as he ideally should for any type of investment, he should hold it against other investments with the same risk reward benefits to evaluate whether the step up bond is a good investment proposition, or not.
The allure of step up bonds is that they are usually seen to offer a higher rate of interest than other categories of fixed income investments. However, it is important to note that it can go either way – the interest rates on fixed income investments can rise quicker than that of the step up rate, or vice versa.
Benefits of investing in step up bonds
Principal repayment:
When you buy a bond, you receive a commission from the bond issuer that you will get back the capital that you have invested, plus interest. This makes bonds a popular investment among investors with a low risk appetite because unlike stocks (where the stock price determines how much capital they will get back), they are happy to receive a guarantee that their capital will be returned, with interest. This is true for all types of bonds, including step up bonds.
Increasing returns:
The most favoured feature of step up bonds, and the main reason for their popularity is the fact that they offer the possibility of increasing interest alongside being fixed income, and offering a guarantee of repayment.
Long term investment:
There are a lot of busy investors out there who favour a passive mode of investing that displays constant proof of delivering good ROI, by regular payouts. Step up bonds could be just what such investors are looking for.
Liquidity:
Because of their benefits, the market price for step up bonds could be quite attractive, especially around interest step ups and interest payouts. Investors could find opportune moments to sell step up bonds at a good market price, should they want to redeem prior to the maturity date. Because of the step up announcements and interest payouts, there is a higher chance for the buzz around step up bonds, which could result in a higher incidence of peaks and more chances for investors to sell at a favourable rate.
Considerations when investing in step up bonds
Very low starting interest rates
Investors are baited into accepting lower rates of interest at the outset because of a promise of higher rates later. But this means that when you purchase the bond, your ROI is very low.
The “callable” bit:
It is imperative for investors to check if step up bonds are callable, and for the most part, they are. Callable bonds can be called or redeemed by the bond issuer at any point prior to maturity. This means that the bond issuer can repay investors and stop paying interest when the interest rates start to get really interesting for investors. The investors suffer the low rates of interest at the beginning and right when they finally arrive at the interest rates that they’ve been waiting for, the deal is swept off the table. They do get back their capital as promised, but not the ROI they had hoped for.
Interest rates and interest race:
The price that the bond will fetch on the stick market is linked to the race between market interest rates and interest rates on the step up bond. If the market rates of interest are higher than the current rate of interest being paid out on the step up bond, the price of the bond will be lower. Conversely, if market rates of interest are lower than the current rate of interest being paid out on the step up bond, the price of the bond will be higher. But if the rates were lower, the investor would be happy to hold on to the bond, in most cases, unless he is selling because he is seeking liquid capital.
Volatility
The interesting rate described above tends to drive substantial volatility to the price of step up bonds and investors seeking to trade bonds on the stock market, rather than hold them would need to have a firm grasp of factors affecting volatility and how the stock market works. They would also need to develop some skills with regard to price predictions and using technical analysis.
Conclusion:
Step up bonds do offer a certain sense of appeal thanks to their rising rates of interest. Investors could consider using them to diversify portfolios or to pursue regular and growing income, provided they take sufficient caution. This means calculating ROI over time and accounting for the possibility of the step up bond being called when interest rates turn truly exciting.
Investors should also remember that bonds are often long-term investments and that early redemption means undertaking stock market trading.
As with any bonds, step up bonds come with default risk and as with any stock market investments, they bear some degree of capital risk. Investors should always consider their risk appetite, and only invest capital available after putting aside a sufficient amount to support one’s lifestyle. It is also always ideal that some regular, fixed income is in place.
