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Most bonds keep a steady interest rate. They pay the same coupon year after year until maturity. Step-up bonds are different in this regard and, for the right investor, can be a stepping stone in their fixed-income portfolio. Read along for a precise guide to all that you need to know.
What is a Step Up Bond?
A step-up bond is a bond whose interest rate increases incrementally at predefined, regular intervals over its life. Everything is spelled out—how much the rate will be and when exactly it will rise. There are no surprises midway.
Think of it like a job that comes with guaranteed salary hikes baked in. You know on Day 1 how often and when your paycheck will grow. The same logic applies here, except instead of a salary, it’s the interest you earn that rises from time to time.
For investors anxious about devoting their money to a long-term bond at a fixed rate, step-up bonds provide the benefit of a no-hidden-rules increase in your returns.
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How do Step Up Bonds Work?
Let’s say a company issues a 6-year step-up bond with the interest structure as follows:
- Years 1-2: 8.5% per annum
- Years 3-4: 9.5% per annum
- Years 5-6: 10.5% per annum
On a ₹1,00,000 investment, that amounts to a ₹8,500+9,500+10,500 = ₹28,500 return across the full tenure. Your average yield comes down to 9.5%, which is better than a bond with a flat 8.5% rate. And more importantly, your income grows as you go, rather than staying consistent throughout.
Types of Step-Up Bonds Available in India
Not all step-up bonds function in the same way. Here’s what differs:
| Type | How the Rate Steps Up |
| Coupon Step Up | Rate increases at fixed time intervals |
| Rating-Linked Step Up | Ratings increase only if the issuer’s credit rating takes a hit |
| Index-Linked Step Up | Rate is tied to an external benchmark (inflation, repo rate, etc.) |
The rating-linked type is particularly favorable for investors. If the issuer becomes financially weaker as compared to when you purchased the bond, your coupon automatically rises to compensate for the added risk you’re now subject to. Like a built-in safety valve.
Must Read: Step-Up vs Step-Down Interest Rate Bonds Explained
Why Do Issuers Offer Step-Up Bonds?
Understanding the thought that goes behind this helps you invest smarter. Companies and institutions issue these bonds for two reasons—
- To attract long-term investors who might be hesitant to invest in today’s flat rate, especially when the interest rates are predicted to rise
- To improve their finances. A company that expects to grow with the years can secure funding at cheap rates now and, if all goes well, be in a position where it can keep paying more to the investors as time goes.
When a creditworthy issuer offers a step-up bond, it signals investors that they are confident in their own future financial health. A sigh of relief for investors worried about long-term returns.
In India, step-up bonds have been issued by PSUs like NHAI, PFC, and REC, as well as NBFCs and corporates looking to find long-term investors, retail and institutional alike.
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Step-up Bonds vs. Regular Bonds: Which Works Better For You?
- Regular bonds fit investors who want predictable returns: retirees, conservative investors, or anyone aiming to build a steady cash flow portfolio
- Step-up bonds suit investors with a longer horizon who seek incremental returns over time
The primary benefit of step-up bonds is that they provide some level of protection against interest rate changes. If rates are rising, flat-coupon bond investors may feel trapped while step-up bond investors reap the rewards because they have a higher rate locked in for the future.
The Biggest Risk of Step-Up Bonds: The Call Option
Many step-up bonds, specifically those issued by banks and NBFCs, come with a call option. This means that they have the right to cancel the bond before the end of its term, and they usually take advantage of this choice just before the rate is set to rise.
To put it simply: the issuer can pay you back right before the rate rises, hence forgoing the higher payout completely. You get your principal back, but your predicted higher coupons are effectively thrown out the window.
Always check for a call option before committing to a step-up bond. It doesn’t necessarily make the investment bad but sours the returns significantly.
Other Risks to Look Out For
- Reinvestment risk—If the bond happens to be called back early, reinvestment at the same or even competitive rates isn’t guaranteed
- Liquidity risk—Secondary market trading opportunities for corporate bonds in India remain slim. Exiting before maturity can be troublesome
- Inflation risk—It might turn out that even the growing coupon payouts are unable to keep up with the inflation
Who Should Consider Investing in Step-Up Bonds?
Step-up bonds work best for investors with a medium-to-long-term time horizon (3+ years) seeking income that is rising, not stagnant, and some protection from increasing interest rates. Just be sure you have done the due diligence on a call option before you commit.
They are not as attractive when you’re in the market for consistent income, when you may want to exit early, or when you aren’t fully comfortable with the effects of the call option on your returns. In case you’re unsure, work out the math before you fall prey to the higher coupons.
Step Up Bonds in India Frequently Asked Questions:
A: It depends on what you want to achieve. Step-up bonds are better when interest rates are likely to increase and you have a long time horizon. Fixed-rate bonds are more predictable and easier for income-oriented investors.
A: Not inherently. The risk depends on the issuer’s credit rating, not the bond structure. A step-up bond with a rating of AAA will be safer than a fixed-coupon bond rated BB. The complexity of the structure does not necessarily increase the credit risk.
A: A call option allows the bond issuer to call the bond prior to maturity, typically just before a rate step-up. Not necessarily a bad thing, but you might not get the higher coupons you had hoped for. Take this into account when investing.
A: Many NBFCs and private corporations have stepped up offerings, along with PSUs like NHAI, PFC, etc. They are regulated and listed instruments, which are usually found on bond platforms like GoldenPi and through brokers.
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Disclaimer:
This information is for general information purposes only. GoldenPi makes no guarantee on the accuracy of the data provided here; the information displayed is subject to change and is provided on an as-is basis. Nothing contained herein is intended to or shall be deemed to be investment advice, implied or otherwise. Investments in the securities market are subject to market risks. Read all the offer-related documents carefully before investing.
Bonds or non-convertible debentures (NCDs) are regulated by the Securities and Exchange Board of India and other government authorities. GoldenPi Securities Private Limited is a registered debt broker and acts as a distributor and not as a manufacturer of the product.
