Coupon Types: Fixed, Floating, and Step-Up

Coupon structures define a bond’s cash flow profile and risk-reward tradeoffs. For institutional investors, selecting between fixed, floating, and step-up coupons directly impacts duration exposure, reinvestment risk, and returns in shifting rate environments. The tension lies in balancing predictability against flexibility—a 30-year fixed-rate bond offers stable income but risks losing value if rates rise, while a floating-rate note (FRN) tied to SOFR + 150 bps adjusts with rates but introduces reinvestment uncertainty.

Market participants must also account for structural complexity. A step-up coupon bond, for instance, might start at 4% and increase by 30 bps annually, offering a middle ground for issuers seeking stable early financing costs while incentivizing long-term holding. This structural diversity creates workflow challenges: modeling cash flows requires precise understanding of reset mechanics, step-up triggers, and index correlations.

Fixed and Floating Coupons: Core Structures Fixed coupons lock in a set rate—e.g., 5% annually—for the bond’s life, simplifying accounting and budgeting. However, in a 200-basis-point rate hike scenario, such bonds may see prices drop 15-20% depending on duration. Floating-rate bonds, by contrast, reset periodically (e.g., semiannual SOFR + 150 bps), insulating investors from rate hikes but exposing them to reinvestment risk if rates fall. FRNs are often used in portfolios targeting low duration, such as bank loans or short-term corporate debt.

Step-Up Coupons: Strategic Flexibility Step-up coupons embed scheduled increases—e.g., 4% at issuance, rising 30 bps each year—to combat inflation or align with long-dated cash flow needs. A 10-year step-up bond might end at 7% by maturity, reducing the issuer’s refinancing risk while providing investors with escalating yields. These structures are common in infrastructure or project finance, where future cash flows are expected to grow. However, they require stress-testing under scenarios where rates rise faster than the step schedule.

• Fixed: Predictable cash flows, high interest rate risk
• Floating: Rate-adjusting, reinvestment risk
• Step-Up: Escalating yields, complex cash flow modeling

Diagnostic next step: Map your portfolio’s duration and rate sensitivity against coupon structures. For example, in a 100-basis-point tightening cycle, a 7-year fixed-rate bond with 4% coupons may underperform a SOFR + 100 bps FRN by 25-30 bps annually, depending on spread compression.