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Glossary

Step-Up & Step-Down Bond

Category — Bond Types
Step-Up and Step-Down bonds are fixed-rate bonds characterized by a trend, determined at the issue of the bond itself, which may be respectively increasing or decreasing over time. The typical predetermined coupon structure or variable over time represents this peculiar characteristic common to both types of bonds.

Example of a bond. In this case we are facing a Step-Up Bond. In fact, it is noted that the coupon rate increases over time. It starts with a rate of 3% and gradually increases over time to a rate of 5%. However, we are not dealing with a variable rate: in fact, these increasing characteristics of the coupon rate are pre-established by contract from the moment the bond is issued and the underwriters are fully aware of this. There are also Step-Up or Step-Down Bonds that link their rate to the rating of an issuer, in this case it is known that in the event that the company undergoes a downgrade the coupon rate would increase by a certain percentage provided.

Similarly, the coupon rates of a Step-Up or Step-Down Bond can be correlated to the performance of certain economic quantities that can strongly influence the company’s activities such as oil for companies in the automotive sectors or the oil industry. In this case, these companies will issue bonds linked to the raw material that will ensure an increasing or decreasing coupon yield over time depending on the performance of the raw material itself.

Why issue Bond Step-Up and Step-Down?

So why should a company issue this type of bond? The answer lies in the desire, on the part of the issuer, to diversify the demand by making it more attractive for subscribers. For example, in the event that the issuer expects that market rates will increase in the near future, it may find it convenient to offer a lower coupon in line with current market conditions to then increase it later when competing rates tend to rise. In this way, it would protect itself by deciding from the beginning of the issue contract how much interest it will pay overtime, but at the same time, it would also attract potential subscribers who could be attracted to an investment of this kind which, as previously mentioned, is safer compared to a floating rate bond.

On the other hand, if a decline in market rates is expected, a higher coupon could initially be offered in line with current conditions, to be subsequently cut, remaining in line with the yields of competing and equivalent issuers by type and grade. risk.

However, there are also disadvantages, such as:
• Interest rate risk: market rates can rise faster than rates of increase;
• Step-Ups sold in advance may suffer a loss if the sale price is lower than the purchase price;
• The higher rates are not guaranteed as some Step-Up Bonds are redeemable.
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