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Step Up to Step-Up Notes

Stepeh Taub

So, now that interest rates are apparently starting to rise, it is a good time to switch some of your fixed-income assets to one of the strategies we have been talking about all year as rates headed closer and closer to their all-time lows.

For example, if you expect rates to rise fairly rapidly, you might want to consider step-up notes. They are high-quality bonds with an above-market interest rate, a call feature and a coupon that increases annually over the life of the bond.
If not called, the coupon increases or 'steps-up' according to a set schedule, thus lessening interest rate risk to the buyer.

What's more, even if the issuer calls the bond on the first possible call date, investors wind up earning a pretty attractive return compared with other short-term instruments whose maturity equals the no-call period. And if the paper is not called, the interest rate keeps increasing as it approaches maturity. Not a bad deal, huh?

"If rates do rise, the step-up's coupons are more likely to provide for an attractive current yield when compared to fixed interest notes even in a new, higher interest rate environment," according to a recent analysis from Citigroup. "And if rates increase only modestly, the investor is likely to earn more on the step-up note than could be earned on many alternative fixed-income investments."

Morgan Keegan, the Memphis, Tenn.-based regional brokerage firm, points out that there are at least four advantages to step-up notes.

* They offer a higher interest rate than is currently available in the Treasury market.

* The coupon increases, or steps up, each year for the life of the bond.

* High-quality issuers include General Electric and Fannie Mae.

* They are the most liquid of all structured notes.

For example, back in May Fannie Mae priced $500 million of five-year step-up notes with a 2% coupon. It is not callable for one year. It then steps up to as high as 3.25%.

Of course, there are some risks.

For example, Morgan Keegan points out that the timing of the principal payment is unknown and, in general, the bonds will be called unless interest rates rise significantly. Also, there is minimal price appreciation compared to fixed coupon notes.

Citigroup recommends investors look at step-up notes as a buy-and-hold investment even though there is an active secondary market. Why? If rates fall, the price of a comparable noncallable bond will probably rise higher since the step-up notes have that callable potential.
However, in a rising rate environment, step-up bonds actually fall less steeply than noncallable bonds due to the increase in the coupon in the future.

It adds: "In summary, step-up notes should be less volatile than either standard noncallable bonds or standard callable bonds, both in increasing and decreasing interest rate environments."
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.