The latest economic data point to an improving U.S. economy with interest rates more likely to rise in the future. For investors who hold traditional bond investments, this scenario poses increased risk to the value of their income portfolios. Is there a way to continue getting steady bond income without having to take the hit to the value of the bonds? As readers of previous posts know, I am not a big fan of bond funds but much prefer direct ownership of bonds held to maturity, partly because it mitigates this interest rate risk. I believe building a bond ladder (or a ladder of defined maturity funds as mentioned in an earlier post) is still the better way to go. But if ladders are not an option for an investor, are there any other alternatives that make sense under these conditions? One type of Investment worth exploring for your portfolio is the step-up bond.
Future Payments are Higher
A step-up bond has a coupon rate that is scheduled to increase (“step-up”) to a higher rate at least once during the life of the bond. If the coupon payment is increased only once, the bond is called a “one-step” bond, and if the coupon is scheduled to increase more than once, it is called a “multi-step” bond. Typically issued by Government Sponsored Enterprises (Fannie Mae, Sallie Mae, etc.) and major corporations, these bonds are callable (redeemable) by the issuer at some future date. Although step-up bonds offer a lower initial coupon rate versus similar fixed-rate bonds, if the bond is never called, the total amount of interest paid over the life of the step-up bond will be greater than the interest paid by a conventional bond that is issued at the same time. An investor in a step-up bond, therefore, sacrifices current income for potentially higher yield over the life of the bond.
The Positives and Negatives of Step-ups
Besides lessening interest rate risk, the advantages of these bonds are that they are issued by high-quality institutions and they can be traded in a fairly liquid secondary market in case you want to sell them prior to maturity. The higher future income is ideal for those whose needs for investment income may be more important down the road. The big downside to a step-up bond, of course, is that the issuer can force you to redeem the bond early by calling it. This will happen if the coupon rises above market rates, thus forcing you to reinvest at a lower yield. You might be able to buy a non-callable type of step-up bond (canary call) to avoid this, but these are not as common. Although the coupon rates on non-callable bonds might be lower than for the callable bonds, you can count on getting the higher yields later.
Considerations for Income Investors
Since interest rates are likely to rise in the future, it is less likely that recently issued step-up bonds will be called. Buying and holding step-up bonds until maturity seems like a reasonable option at this time. A couple of things to keep in mind as you investigate further: 1) the higher the coupon rate and the closer it is to the maturity date, the more likely it is that a step-up bond will be called, and 2) most step-up bonds pay interest only every six months, so if you want income quarterly or monthly, you might want to consider other alternatives.