A step-up bond is a type of bond which pays out yields at progressively higher rates across the bond term.
The term of a step-up bond is normally made up of a number of sub-terms. These are typically 1 year each. The interest rate used for coupons increases every time a new sub-term begins. The coupons of a step-up bond can be seen as steps or tiers, with each coupon paying out higher yields than the previous coupon.
While conventional bonds pay out an annual yield that is fixed across the bond term, the yields paid out by step-up bonds increase at intervals throughout the bond term. Typically, yields increase every year.
Example: A company issues a step-up bond with an 8-year term. The bond pays a coupon with an annual interest rate of 0.5% the first year. For each subsequent year, the coupon increases by 0.5%. So the bond pays out 2% interest for the fourth year and 4% interest for the eighth year.
The disadvantage of step-up bonds is that issuers reserve the right to require investors to redeem these bonds at the end of each interval after settling payment of yields. This means that, should a borrower find a cheaper source of financing, it may withdraw from the bond agreement after paying the annual coupon by repaying the bond principal to the investor. So while step-up bonds may promise high coupon payments, there is a risk that investors will not end up being able to redeem the highest-value coupons.
In the example above, the company could, for example, terminate the step-up bond after paying out the 0.5% coupon for the first year. In that case, the investor would not be able to attain the higher yields offered for subsequent years.