You were searching for a job and now you have 2 offer letters. Job A offers you a fixed salary of Rs.60,000 per month fixed for the next five years. Job B offers Rs.55,000 per month, but gives you a guaranteed raise to Rs.65,000 per month after two years.
Which one would you opt for? Your answer shall probably depend on what you expect to happen in the future.
Investing in bonds is similar to this, when you buy a bond, you lend your money to the bond issuing entity, a company or the government. In return, the entity promises to pay you regular interest and return your initial money after a fixed period. Most bonds are identical to Job A, they pay a fixed interest rate that stays fixed for the whole period.
But what if you invest in a bond that is similar to Job B where the interest gets increased after a period of time, giving investors a pre-planned raise. Well, there is and it is known as a Step Up Bond, these bonds are designed for investors who like the idea of growing their income over time.
What is a Step-Up Bond?
A Step Up Bond is a type of bond that starts by paying a lower interest rate, but this rate increases at fixed, pre-planned times during the bond’s life. These bonds start with a lower interest rate and after a set period the interest rate automatically rises and you start to get a higher interest rate on the same invested amount.
This increase in the interest rate is pre-defined by the bond issuing entity on the day of bond issuance. The company or government issuing the bond will clearly state how often the interest rate will increase, by what percentage it will increase and a pre-decided date of rate increase.
Investors like this as the income from a step-up bond is predictable. The main reason these bonds exist is to offer some protection to investors in a world where interest rates can change. If your funds are locked into a regular bond with a 7% interest rate and new bonds are suddenly being offered at 8%, you might feel like you are missing out. A step-up bond tries to solve this problem by building those future rate hikes right into its structure in the beginning itself.
Read Also: Detailed Guide on Bond Investing
How do Step-Up Bond work?
Let’s look at some numbers and understand how it works.
Suppose you invest Rs.10,000 in a 5 year step-up bond from a company called ‘Pocketful India Ltd.’. The bond’s terms are:
- For the first 2 years, there would be a fixed interest rate of 6% per year.
- For the next 3 years, the interest rate will “step up” to 8% per year.
| Year | Your Investment (Principal) | Coupon Rate for the Year | Annual Interest You Earn |
|---|---|---|---|
| 1 | Rs.10,000 | 6.0% | Rs.600 |
| 2 | Rs.10,000 | 6.0% | Rs.600 |
| 3 | Rs.10,000 | 8.0% (Step-up) | Rs.800 |
| 4 | Rs.10,000 | 8.0% | Rs.800 |
| 5 | Rs.10,000 | 8.0% | Rs.800 |
| End of Year 5 | You get back your initial investment of Rs.10,000. |
Features of Step-Up Bonds
- Scheduled Increased Interests: This is the main feature of these bonds, where the interest rate increases at a pre-decided time interval, like every year or after a few years.
- Fixed Maturity Date: The bond has a clear end date. This is the date when the issuer is supposed to return your principal amount.
- Issuer Types: In India, step-up bonds can be issued by various entities, which includes government-backed institutions like HUDCO (Housing and Urban Development Corporation) and NHAI (National Highways Authority of India), as well as private companies like Shriram Finance or L&T Finance.
- The Callable Feature: This means the issuer has the right to end the bond early and can return your principal before the maturity date. In this you get your money back, but you lose the opportunity to earn the higher interest rates you were waiting for.
Read Also: What are Bond Valuation?
Benefits of Investing in Step-Up Bond
- Growing Income Stream: Investors earn through the increasing interest over time. This can be helpful for long-term financial planning and tackling inflation.
- Increasing Interest: If you believe interest rates in the economy are going to rise in the future, a step-up bond can be a good way to make sure your invested income will also rise with time.
- Calculable Returns: Even though the investment increases, it grows on a fixed schedule and investors know exactly what to expect and at what time.
- Portfolio Diversification: Adding step-up bonds to your investment is a good way to diversify your fixed-income portfolio beyond regular FDs and traditional bonds.
Key Factors to Look For
- Call Risk : Call means the bond could be called back early before the expiry date. This means you might not get the desired interest rates that attracted you in the first place.
- Low Initial Returns: To get the promise of higher rates later, you have to accept a lower interest rate at the beginning. This might be lower than what a regular fixed deposit or a traditional bond offers at that time.
- Market Risk: If you need to sell your bond on the stock market before it matures, its price can be lower than what you paid.
Taxation in India
Like most investments, the earnings from step-up bonds are taxed. The interest you earn from the bond each year is added to your total income and taxed according to your income tax slab.
The bond issuer will usually deduct 10% tax on the interest before paying it to you. You can claim this back or adjust it when you file your income tax return. Also additionally there will be a Capital Gains Tax, this applies only if you sell the bond on the stock exchange before its maturity date. If you hold the bond for more than 12 months, any profit is a Long-Term Capital Gain (LTCG) and is taxed at 10% (without indexation). If you sell within 12 months, the profit is a Short-Term Capital Gain (STCG) and is added to your income.
Read Also: Benefits of Investing in Bonds
Conclusion
Step-up bonds are a unique financial tool that offer an interesting solution for investors who want the safety of a bond but are worried about rising interest rates. These bonds provide a clear, scheduled path to a growing income. However, there is also a possibility of call risk where your predicted future income can be hampered.
By opting a step-up bond is a strategic decision based on your future needs. If you plan to earn slow rising interest rates with time then step-up bonds are best suitable for you. Make an informed choice keeping your future expectations in mind.
Frequently Asked Questions (FAQs)
Biggest risk of a step-up bond?
The biggest risk is the “call feature,”where the issuer can return your money before maturity, potentially causing you to miss out on the promised higher interest rates in the future.
Which is a better investment option, step-up bonds or fixed-rate bonds?
Step-up bonds are potentially better if you expect interest rates to rise periodically, while fixed-rate bonds are better if you expect rates to fall or stay stable. It totally depends upon your future goals.
Can initial investment be fully lost in a step-up bond?
Investors generally get the full invested amount back, if the bond is held till maturity, unless the issuer defaults (fails to pay), which is a risk with any bond. If you sell the bond before maturity, you are expected to get a lower price than what you have initially paid..
Who can issue step-up bonds in India?
They can be issued by both government-related entities (like HUDCO, NHAI) and private sector companies (like Shriram Finance, L&T Finance, and other NBFCs) to raise money from the public.
