Step-up bonds are variable rate bonds that have a coupon rate that keeps rising over time. The main reason why they are referred to as gallop bonds is due to the rate of interest on the bond Growing as time passes.
Step-up bonds are advantageous to creditors as it enables them to benefit from raising interest rates but perhaps more disadvantageous to the borrower. Usually, government agencies issue step-up bonds.
From time to time, the initial coupon rate of step-up bonds may be reduced as compared to the interest rate provided on other fixed-income instruments on the market.
Similarly, while there are many advantages of step-up bonds to creditors, there are still some disadvantages that they need to understand. These disadvantages arise as a result of inherent dangers associated with these types of instruments.
It is the worth of the tool that investors pay for in money. Similarly, they also have a coupon rate, which for step-up bonds is usually variable and increases after specific intervals of time.
Bonds also have a maturity date, that’s the time when investors become repaid for the face value of the bond. Usually, bonds have been fixed-income debt tools, but step-up bonds are distinct.
Example Step Up Bond
For example, a creditor pays buys a fixed-income bond for $1,000 by a business that offers a coupon rate of 4 percent with a maturity of 5 decades.
It means, annually the lending institution will get an interest payment of $40.
On the other hand, step-up bonds are distinct. The creditor may receive a lower coupon rate initially, which will increase since the bond ages. For example, a creditor pays $1,000 to get a step-up bond that offers a coupon rate of 3 percent initially with maturity after five decades.
The coupon rate of 3 percent only applies to the first two decades of the bond and for the next two decades, the coupon rate rises to 4.5 percent. The coupon rate of the bond increases to 5 percent in its final year.
It means that the lender will get $30 for each of their first two years, $45 for two and year three, and eventually receive $50 in the last year. The bank will also get $1,000 on the maturity of the bond, as usual.
Different types of Step-Up Bonds
There are two chief types of Step-Up bonds that debtors may issue. All these types are single step-up bonds along with several step-up bonds.
Single step-up bonds are the type of step-up bonds where there is simply a single increase in the coupon rate of the bond, over its life.
By way of example, a bond with a maturity of 5 years might have a coupon rate of 3 percent initially, which will increase to 5% after two years and employ throughout the maturity of the bond.
Multiple step-up bonds are the type of step-up bonds in which there are plenty of changes in the coupon rate of the bond within its lifecycle.
For instance, a bond includes a 5-year maturity and may have an initial coupon rate of 3%. The coupon rate increases to 4% after two decades. It increases even further to 5 percent for the past year of this bond.
Benefits of Step-Up Bonds
As previously mentioned, step-up bonds have many advantages for the creditor. The primary advantage of step-up bonds to lenders is that it lets them benefit from an increased income as compared to fixed-rate bonds. That means lenders can get greater returns through step-up bonds if they choose them over fixed-income bonds.
By way of instance, if a fixed-income bond offers a coupon rate of 5 percent while the lender also has a choice to invest at a 5% step-up bond, the step-up bond is the better choice.
But, step-up bonds can also be helpful for the borrower. Most step-up bonds arrive with a callable attribute, using which they could induce creditors to redeem the bonds.
Therefore, borrowers may escape the loan whenever they want to. It may be particularly beneficial for businesses that are looking to increase quick finance by providing creditors an incentive but not permitting the incentive to realize.
The advantages mentioned previously are also disadvantageous for the other party. For borrowers, they must pay a higher interest rate as compared to some fixed-income bond.
On the other hand, lenders always face the risk of the debtor calling the stocks, so, not letting them benefit from a rise in the speed of their bond.
Step-up bonds are the type of bonds that come with a varying increasing coupon rate. These are far better than fixed-income bonds, and permit lenders to get a greater interest in the bond. There are two chief types of step-up bonds, single step-up and several step-up bonds.
In one step-up bond, the coupon rate of the bond growth just once, while in multiple step-up bonds, the coupon rate rises several times over the bond’s lifecycle. Step-up bonds may have advantages and disadvantages for both the creditor and the borrower.