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I keep reading that "a step-up bond provides more protection to an investor in the face of market interest rate fluctuations", that "a step-up bond typically performs better than any other fixed-rate investment in a rising rate market", etc.

To me, this appears completely wrong. Compared to a fixed rate bond (of the same issue price and face value, maturity, seniority etc.) a step-up bond should have a higher duration, i.e. a higher sensitivity to market interest rate fluctuations. In particular, if market rates go up, the market price of the step-up should decrease more, not less. In this sense the "ultimate" step-up is the zero-coupon, that can be seen as paying 0% coupons for most of its lifetime, and a single stepped-up coupon equal to the difference between the face value and issue price at the very end; and indeed as I understand it zero-coupons are, roughly speaking, the "vanilla" bond type with the longest duration for a given maturity.

Am I mistaken? Am I missing some unspoken assumption often made in such cases?

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2 Answers 2

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In my opinion you are right. A fixed maturity “step-up” bond performs very similarly to a coupon bond whose coupon is the average of the coupons on the step up bond. That’s pretty much all there is to it.

If you compare the step up bond to a fixed coupon bond whose coupon is the lowest of the “steps”, then yes the step up bond has a higher dv01 and a higher price. It’s also true that the step up bond has a lower Macaulay duration, because it’s price is higher. So it depends how you compare the bonds.

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  • $\begingroup$ Ah ok. Both this answer and the next clarified the unspoken assumptions that might have motivated some of what I read (but not all!). Basically, I was thinking about bonds with issue price equal to face value, so that a step-up (compared to a fixed rate) must have lower coupons earlier so as to have higher ones later. But if you compare a step-up with a fixed rate whose coupons equal to the initial coupons of the step-up, sure, the duration of the step up for the same maturity is lower (because it will have lower face value for the same issue price). Thanks! $\endgroup$
    – BabaYaga
    Commented Jul 5, 2020 at 23:42
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(All of this from the investor point of view) Vanilla bonds have positive returns when market rates decline and negative returns when market rates go up. Step up bonds have 2 reasons they may outperform in a rising rate environment. First, the higher coupon on the step up will result in the bond having a lower duration versus a comparable vanilla at the low coupon. Second, high coupon bonds are considered defensive because of convexity effects (especially when priced at a premium).

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