Step Up to the Plate

Marilyn Cohen, Forbes Magazine, 01.26.98

THE BOND MARKET has been on a tear. The rate on the long Treasury has declined from 7.1% last spring to 5.8% as I write. In my view, the bond market is due for a modest setback -- very modest, but enough to make most bond investments eminently postponable.

Except for step-up bonds. Never heard of them? Ill explain. A step- up bond starts out with a coupon that is slightly above the going rate for short-term bonds. After a period (typically, one to three years), the coupon kicks up to a higher rate. The issuer, however, has the right to call the bond early (usually at par) at that point. In all likelihood, the bond will be called just before it steps to a higher coupon.

In other words, you probably will never see the next fat coupon. But if you think as I do that interest rates will resume their downward move later in the year, step-up bonds are in effect short-term bonds with interest rates more like those on longer-term bonds.

Heres one: In late December the Federal Home Loan Bank issued a bond with final maturity in January 2003 and an initial interest rate of 6%.

The coupon kicks up in stages, to 6.375% beginning in January 1999, then to 6.5% for a year, then to 7%, then to 8% for the last 12 months. The issuer can call the bond on any of the reset dates, and it probably will call the bond, either a year or two years from now.

If you buy this bond now (its trading close to par), you are probably buying a one-year bond paying 6%. A straight FHLB bond due in January 1999 yields 5.7%. The payoff on step-ups is an interest bonus.

So you get a small, 30-basis-point increment of yield in return for taking the slight risk that the bond wont be called. At worst -- if interest rates go up, not down -- you might end with an average rate of 7% in a world where high-grade credits like this are paying -- who knows? -- 8% or 9%. But thats if inflation comes roaring back.

These step-ups are not for those who are outright bullish on bonds.

If you think interest rates will keep falling without rebounding, dont waste your time on something that will probably live for only a year or two. Buy a 20- or 30-year issue. And make sure its noncallable.

Nor should you contemplate a step-up bond if you are extremely bearish. If you think medium-term interest rates will indeed climb to 8% or 9%, put your cash in a money market and wait for a better buying opportunity. Step-ups are for those -- like me -- who think interest rates will go lower but not without an occasional reversal.

You can buy step-ups in almost every credit category. The lions share is issued by gold-plated issuers, including government-sponsored agencies (Fannie Mae, Sallie Mae, Freddie Mac, Federal Home Loan Bank) and corporations like Colgate-Palmolive, GE Credit and Xerox Credit. If you want to reach for yield, lower-rated corporations also get into the act. Which kind you want to buy depends on your interest rate outlook and how well you want to sleep at night.

With a junk step-up you are taking a chance on two possible adverse outcomes -- that the bond market tanks or the issuer gets into financial trouble. If either of these events occurs, the money that you thought would be returned to you quickly is returned slowly or not at all.

Thats a bet, but sometimes you get paid well for taking it. Three years ago you could have bought Imax bonds due in 2001 and stepping up from an initial 7% coupon to 10% in March 1997. The bonds were trading a little below par -- at $975 per $1,000 of face value. That gave a yield- to-worst-call of 9.7%.

This year profits are rolling in from the 144 oversize theater screens Imax has built in 21 countries. The bonds are trading at 105, and I expect Imax will call them on Mar. 1 rather than pay another 10% coupon.

A word of caution: If you want to put some money to work in step-up bonds, be prepared to hold them until call or maturity. Getting a fair bid in the aftermarket is a dicey proposition, especially for some of the smaller corporate issues.

Purchase step-up issues with a buy-and-hold mindset.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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