Step-Up Bonds Are an Alternative as Interest Rates Remain Low

After more than six years of low interest rates, it’s still unclear when they might move higher.

The estimates of when the Federal Reserve will raise rates range from March 2015 to early 2016, said Craig Elder, a fixed-income analyst in Robert W. Baird & Co.’s Milwaukee office.

Even when the Fed raises rates, the move probably will have a much bigger effect on shorter-maturity instruments than 10-year and 30-year bonds, Elder said.

To have an effect on the longer maturities, the Fed would have to start trimming the size of its $4.4 trillion bond portfolio, he said. The Fed stopped investing new money in the bond market under its quantitative-easing program at the end of October, but it is still buying bonds when holdings mature, Elder said.

Sticking with cash has not been the safe haven it might have seemed.

“People who have kept money in cash over the last five to six years don’t realize that earning nothing has really cost them,” he said.

Still, fixed-income investors have the same dilemma they’ve had for years: Is it better to lock in higher rates on long-term bonds, knowing those rates might not look so good in a year or two? Or is it best to settle for the paltry rates on shorter-term securities, all the while feeling like it’s hardly worth it?

Elder says there’s another solution.

Step-up bonds, issued by agencies like Fannie Mae, Freddie Mac and the Federal Home Loan Bank, pay an initial coupon rate until a call date. If the security is not called, the coupon is adjusted to a higher rate at least three more times, Elder said.

This structure removes some of the maturity risk for investors without requiring a significant sacrifice in yield, Elder said.

Most of the step-up bonds now on the market have their coupon rate adjusted higher on an annual or semiannual basis, he said. They are all structured slightly differently.

“You can go out five to 10 years,” Elder said. “Some have a huge coupon on the end you’re not likely to ever see because the bond would be called way before then.”

But if the bond is not called, you get a high yield. If it is called, you likely would get your money back in a higher-interest-rate environment, he said.

Step-up bonds are not guaranteed by the federal government, but Elder said none of the agencies issuing them has ever missed a payment.

Given the high ratings step-up bonds have received for their credit quality, Elder said it isn’t imperative that investors have a diverse portfolio of maturities. It is enough to determine when the money might be needed and buy a step-up bond with that maturity, he said.

There are some corporate bonds with step-up rates, but investors take credit risks with those, he cautioned.

Step-up bonds trade actively and are available from any broker, Elder said. Each broker will have a different inventory of bonds, but here are some recent new issues, all of which were at par last week.

– Federal Home Loan Bank step-up bond maturing in November 2017.

This bond pays 0.50 percent until May, then 0.75 percent until November and 1 percent until May 2016. Then the rate rises by half a percentage point every six months until maturity. The bond is rated AAA by Moody’s and AA+ by Standard & Poor’s, Elder said.

– Federal Home Loan Mortgage Corp., or Freddie Mac, step-up bond maturing in December 2019.

This bond pays 1.5 percent until December 2015, then 1.75 percent until December 2016 and 2 percent until December 2017. Then the rate rises by half a percentage point every year until maturity. The bond is rated AAA by Moody’s, Elder said.

– Federal Home Loan Bank step-up bond maturing in December 2022.

This bond pays 2 percent until June 2018, then 2.5 percent until June 2020 and 3 percent until December 2020. Then the rate rises by one percentage point every six months until June 2022. After that, it pays 8 percent until maturity. The bond is rated AA+ by S&P, Elder said.

This article appeared in print in the December 9th, 2014 edition of Hamodia.