The High Cost of Waiting

The callable step-up investment is another strategy that is gaining investor attention. As the name implies, callable step-ups do not pay a constant rate of interest over the life of the instrument; rather, they pay a predetermined schedule of coupon rates. The rates begin somewhat below that of similar fixed-income investments and gradually increase, or “step up,” over a specified timeframe. The coupon may step up only once or as often as annually until the investment is called by the issuer or it matures, whichever occurs first. Step-ups are sold at par, and most have final maturities of fifteen years or less.

Typically, a step-up also becomes callable on the first date that the coupon resets and is callable either semi-annually or at any time thereafter. Investors can choose step-ups that are issued by Government Sponsored Enterprises (GSEs), such as Freddie Mac and Fannie Mae. Banks also issue Certificates of Deposit (CDs) as step-ups, and CDs enjoy certain benefits such as FDIC insurance and possibly a survivor’s option, which allows the estate to redeem the certificate in the event of the owner’s death.

Callable step-ups may attract investors because they may provide a greater overall weighted average coupon than comparable fixed-rate investments. That is so because even though the coupon paid on a step-up is initially somewhat lower than the rate available on a comparable fixed-rate investment, the step-up eventually increases to a level that is considerably higher than the fixed-rate, if it is not first called by the issuer. The step-up investor chooses to sacrifice some interest income in the early years in exchange for the potential to receive a higher yield over the life of the investment.

Callable step-up investments generally attract investors who are expecting interest rates to rise, but who are also seeking protection if rates rise more than expected. In this scenario, the increasing coupons may keep pace with rising market rates, which can help to offset unfavorable price movements.

Alternative #3: Floating-Rate Investments

Another choice for investors who believe that interest rates may rise is a floating-rate investment that keeps pace with rising interest rates. A floater is a bond with an interest payment that “floats” or adjusts periodically based upon the rate of an underlying index such as LIBOR (London Interbank Offered Rate) or the T-bill rate. Because a floater’s interest payment changes from time to time, based upon changes in market rates, it is well suited to keep pace with rising rates.

Another benefit is that a floater’s market price is less sensitive to changes in the interest rate environment compared to fixed-rate bonds. It is important to note that since short-term rates are usually lower than long-term rates, the initial coupon of a floater is typically lower than that of a fixed-rate note of the same maturity.

Floating-rate investments may have a stipulation by which the coupon can move up or down, within a certain collar or range. A cap can limit the potential return to the investor, while a floor protects the investors on the downside. For example, a floating-rate structure issued with an interest rate equal to the three-month Treasury bill plus 40 basis points may have a cap of 3% and a floor of 1%.

Putting It Together

Each of the bond strategies mentioned might be appropriate for investors who are unsure as to the direction of interest rates. While no one can control the direction of rates, depending on their investing goals and time horizons, investors may not want to risk the costs of waiting on the sidelines. Further, a portfolio that is properly diversified among asset classes helps to reduce overall portfolio risk.