Understanding callable step-up bonds

What if a bond promises that its coupon can go higher the longer you hold it, but the issuer could take it back just before the higher coupon is paid?

That is the key dynamic behind callable step-up bonds. While the prospect of rising coupon payments can be attractive to investors, the issuer’s right to redeem the bond early means those higher payments are not guaranteed. Understanding this trade-off is essential when evaluating potential returns and risks before investing. 

A bond that pays more, but with a catch?

A callable step-up bond is a debt security that combines two features. First, it includes a call option, which gives the issuer the right, but not the obligation, to redeem the bond before its maturity date. Second, it has a step-up coupon, meaning the coupon interest rate increases at predetermined dates.

In a traditional fixed-rate bond, the coupon remains unchanged until maturity. In contrast, a step-up bond has a predetermined coupon schedule in which the coupon rate increases on specified dates throughout the life of the bond. Both the coupon rates and their effective dates are specified in the bond’s prospectus.

Consider a hypothetical 10-year callable step-up bond issued by XYZ Corporation: 

• 4.00% coupon: Years 1 to 5
• 5.00% coupon: Years 6 to 8
• 6.00% coupon: Years 9 to 10
• First call date: end of year 5
   

At the beginning of year 6, the coupon rate increases from 4.00% to 5.00%, and at the beginning of year 9, it rises further to 6.00%. These predetermined increases cause the coupon rate to step up progressively over the life of the bond, hence the term “step-up coupon.”

The step-up feature can provide investors with higher income if the bond remains outstanding. At the same time, paying higher coupon rates may encourage the issuer to redeem the bond before the scheduled step-up dates, especially when market interest rates have fallen.

In such cases, the issuer may choose to refinance by issuing a new bond at a lower borrowing cost, thereby preventing investors from receiving the higher future coupons.
 

More income, more trade-offs

Potential for Higher Income: If the bond remains outstanding, investors benefit from the scheduled increase in coupon payments, thus, potentially enhancing their income overtime.

Call Risk: If the issuer decides to redeem the bond before the scheduled step-up, then investors may not receive the higher step-up coupon they were expecting.

Reinvestment Risk: If the bond is called when prevailing market interest rates are lower, investors receive the face value of their investment, but they may have to reinvest the proceeds at less attractive rates.

Yield Considerations: Investors should look beyond the bond’s Yield to Maturity (YTM) and consider its Yield to Call (YTC), which estimates the return assuming the bond is redeemed on a specified call date instead of the maturity date. 

Two paths, two outcomes

Consider the same hypothetical bond issuance.

If the issuer calls...

Suppose market borrowing costs have declined by year 5. This gives XYZ Corporation the option to issue a new bond at a lower rate, such as 3.50%. The issuer may decide to call the bond rather than continue paying the higher coupon.

Investors receive the face value of their investments but forgo the opportunity to earn 5.00% and 6.00% in the years ahead.

If the issue holds on...

If issuing costs remain relatively high, the issuer may decide that calling the bond is not economically attractive. The bond remains outstanding, allowing investors to receive the scheduled 5.00% beginning in year 6 and 6.00% beginning in year 9.

However, these higher coupons may still be below prevailing market yields, so investors could earn less than the yields on newly issued bonds. 

The bottom line: Don’t chase the headline coupon

Callable step-up bonds can offer the potential for increasing income, but the higher coupons should not be viewed as guaranteed returns. The very feature that makes the bond attractive to investors is the step-up coupon, but it can also make it more attractive for the issuer to redeem the bond.

For this reason, investors should look beyond the headline coupon and evaluate the call schedule, YTC (when the issuer decides to pay off early), YTM (when the bond is held to maturity), call price, issuer credit quality, and the prevailing interest-rate environment.

Instead of just asking “How high can the coupons go?”, also ask, “How likely is the bond to remain outstanding long enough for me to receive it?”

MARIEL LOPEZ is an Investment Counselor at Metrobank, with experience in Trust Banking. She holds an AB Political Economy degree from the University of Asia & the Pacific (UA&P), an MBA from the Ateneo Graduate School of Business, and has completed the Registered Financial Planner (RFP) course. Outside of finance, she enjoys reading, teaches barre, and competes in Hyrox.