The bond investor who wants the benefit of higher rates has a dilemma. Should he or she wait for higher rates, staying short on the yield curve and sacrificing current income? Or go out on the yield curve, capturing some of the rate rises to come and adding risk?
There is a compromise solution in step bonds, a.k.a. “steppers,” which are issued by government and corporate borrowers.

For example, the 2005 Ontario Savings Bonds, often called Osbies, have rates that range from 2.25% for the period June 21, 2005, to June 20, 2006; 2.75% to June 20, 2007, 3% to June 20, 2008, 3.5% to June 20, 2009, and 4% to June 20, 2010. The ’03s, ’02s and ’01s were more generous and the ’96 issue, which started at 4.5% and notched up to 9%, was downright heavenly. The Osbies are good vehicles for pacing rising rates. While conventional bonds drop in market price as interest rates rise, the Osbies don’t.

Steppers issued by corporate borrowers often have call features that allow the issuer to pay off holders under specified conditions or dates. For example, a Royal Bank of
Canada five-year stepper due July 22, 2010, was offered in mid-July with a 3.10% coupon for the first year, 3.3% for the second, 3.75% for the third, 4.15% for the fourth, and 4.6% for the final year. The bond is callable on its anniversary date each year and comes with a year of call protection. The initial yield is close to the 3.25% yield to maturity on the Royal Bank 6.75% due June 3, 2007. Five years out, the Royal Bank 6.3% of April 12, 2011, is priced to yield 3.95%. That’s less than the nominal 4.6% on the step bond. But the average yield on the stepper is 3.75%. It’s a package that offers a decent return each year, with an incentive to hold it to maturity.

Behind the convenient packaging, the bond turns out to be a series of bets the holder is not likely to win. If interest rates rise dramatically, the holder will suffer an opportunity loss if he keeps the bond to maturity, and a cash loss if he sells it before maturity. If rates fall, then the bank can exercise an annual call on the issue’s anniversary date. The bond has just one year of call protection and provides no sustained ability to participate in a bond rally generated by a rate decline.

This amounts to a deal in which, if rates rise a good deal, the investor is stuck with the bond. If rates fall, he loses the bond. It’s heads you lose, tails the issuer wins. Thus, the
Royal Bank stepper works only if rates stay within a band of lower interest rates in which the bank is content to let the bonds ride without a call. Finally, the bond is destined to float in the twilight of small issues, for at $15 million offered (plus another $10 million available at the issuer’s option), it will have bid-ask spreads that discourage institutional buyers. Active managers will find that spread a roadblock to trade or swap strategies, says Peter Kotsopoulos, executive vice president for fixed income at McLean Budden Ltd. in Toronto.

A retail product

“Step bonds tend to be a retail product,” Kotsopoulos says. “The retail investor is more inclined to accept a higher coupon down the road in exchange for a smaller one in the present.”

The longer the step bond has to run to maturity, the more elaborate the analysis it requires. Consider the 10-year stepper sold by the Bank of America in May, 2004. It started with a 4.5% coupon in the year ended May, 2005. Payouts then climb incrementally to 6.5% in the final year ending May, 2014. If the bond was not called until 2014, it would have an average yield of 5.5%.

The problem of the callable stepper comes down to one of rate prediction. If rates stay within the band predicted by the bond’s graduated rates, the holder gets what he expects.
If rates fall a lot, he loses. If rates rise a lot, he suffers at least an opportunity loss, for his money will be tied up in a stepper that has become a clunker.

@page_break@“With step bonds, you have sold an option to the issuer if the bond is callable,” says Richard Gluck, principal at Trilogy Advisors LLP in New York. “If there is a call feature in the bond, you should be paid a higher rate. Thus the question is, are you being paid enough? You need a model for pricing the option in the bond. Retail investors don’t have that equipment. For them, it is a feel-good product.”

What’s more, the investor who wants a rising interest rate bond or a bond that paces inflation has more choices than steppers. Variable rate bonds that adjust payouts according to a formula that accompanies the bond, real return bonds that pace inflation, and convertible bonds that turn into common stock that can rise with inflation if the issuer does well, can all do what step bonds do — pay more money on a nominal or real basis.

This leaves the question of which sort of bond is best for the investor who wants some inflation protection and who is willing to accept complexity and a measure of illiquidity.

A stepper with no risk of call offers some compensation in higher income as interest rates rise. It has relatively superior returns should rates fall. The longer the span of the stepper, the higher its intrinsic value will be. If the bond is negotiable, as most are (with the exception of savings bonds), it should have premium value in the market.

So is a stepper with no call liability the best of all possible worlds? Not necessarily. A long-term investor who thinks interest rates are headed down for decades to come may get a higher return in a long bond or a long strip.

An investor concerned about preserving long-term purchasing power, would do well to buy real return bonds, such as the 3.0% Canada RRB due Dec. 1, 2036, and recently priced at $124.45 per $100 face value to yield 95% to maturity. That’s a paltry return, but like a property and casualty insurance policy that covers every form of mayhem that can possibly happen, a three-decade-long, inflation-proof bond is costly.

But steppers do offer the retail investor limited protection from moderate interest rate gains. They won’t make you rich, they won’t leave you poor, and, if they work as expected, the holder won’t have to worry about the cage match fights that go on in the real world of finance. IE