Coupon Types: Fixed, Floating, and Step-Up

Choosing the wrong coupon structure in a rising rate environment cost fixed-rate holders 15-20% in 2022—while floating-rate investors lost less than 1%. In real market data, bank-loan funds (floating rate) lost just 2.5% that year versus intermediate core bond funds losing over 13% (Jacobsen and Boller, 2024). The practical point isn't that floaters are "better"—it's that coupon structure determines how your bond behaves when rates move, and matching structure to rate outlook prevents painful mismatches.

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Why Coupon Structure Matters (The Rate Sensitivity Question)

Your bond's coupon type answers a critical question: does your income stay fixed while the world changes, or does it adjust?

The causal chain:

Interest rate change → Fixed coupon unchanged → Bond price adjusts to match new market yields

Interest rate change → Floating coupon resets → Bond price stays near par

This is why coupon type selection isn't a minor detail—it's the primary driver of your bond's behavior in changing rate environments. Get it wrong, and you're swimming against the current. Get it right, and rate movements work with you (or at least don't hurt you).

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Fixed-Rate Coupons (When Stability Is the Goal)

Fixed-rate bonds pay the same coupon from issuance to maturity. You buy a 5% coupon bond, and you receive $25 per $1,000 face value every six months for the life of the bond (assuming semi-annual payments, the standard for most corporate and Treasury securities).

When fixed coupons work for you:

• Rates are high and expected to fall (you lock in today's high income)
• You need predictable cash flows for liability matching
• You're holding to maturity and don't care about interim price fluctuations

When fixed coupons work against you:

• Rates rise after purchase (your below-market coupon makes the bond less valuable)
• You need to sell before maturity during a rising rate cycle
• Inflation accelerates, eroding your fixed income's purchasing power

The 2022 lesson: Investors holding intermediate-term fixed-rate bonds lost 13%+ as the Fed raised rates from near-zero to over 5%. The math is unforgiving: when new bonds offer 5% coupons, your old 2% coupon bond must trade at a discount to compete.

The practical rule: Fixed-rate bonds are a bet that current rates are attractive. If you're buying fixed when rates are historically low, you're accepting significant duration risk.

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Floating-Rate Notes (Why Rate Sensitivity Disappears)

Floating-rate notes (FRNs) pay coupons that reset periodically—typically quarterly—based on a reference rate plus a fixed spread. The spread is determined at issuance and reflects the issuer's credit risk.

The formula:

Coupon = Reference Rate + Fixed Spread

Example: A corporate FRN priced at SOFR + 150 basis points with SOFR at 4.30%:

• Current coupon: 4.30% + 1.50% = 5.80%
• If SOFR rises to 5.00%: coupon resets to 5.00% + 1.50% = 6.50%
• If SOFR falls to 3.00%: coupon resets to 3.00% + 1.50% = 4.50%

Why prices stay stable: Because each coupon payment adjusts with market rates, the bond doesn't need to trade at a discount (or premium) to offer market-competitive returns. Your coupon moves, so your price doesn't have to.

The point is: floating-rate notes have near-zero duration. While intermediate fixed-rate bonds might have duration of 4-7 years (meaning a 1% rate rise causes roughly 4-7% price decline), FRNs typically have duration under 0.3 years.

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Reference Rates (What Your Floater Floats On)

SOFR (Secured Overnight Financing Rate): The dominant USD reference rate since LIBOR's 2023 cessation. Based on approximately $1 trillion of daily overnight Treasury repo transactions. Published by the New York Fed. Most new USD floating-rate securities reference SOFR.

How SOFR differs from legacy LIBOR:

• SOFR is transaction-based (actual trades); LIBOR was survey-based (bank estimates)
• SOFR is secured (collateralized by Treasuries); LIBOR was unsecured
• SOFR eliminated manipulation risk that plagued LIBOR

Treasury FRNs: Reference the 13-week T-bill auction rate, resetting weekly with interest paid quarterly. Fixed spreads are typically 10-20 basis points above the index rate.

Spread hierarchy by issuer credit:

• Treasury FRNs: SOFR + 10-20 bps
• World Bank/supranational: SOFR + 25-35 bps
• Investment-grade corporates: SOFR + 50-100 bps
• High-yield corporates: SOFR + 200-400+ bps

The durable lesson: wider spreads mean higher credit risk, not a better deal. A SOFR + 350 bps note pays more income because the issuer is more likely to default—the spread is compensation for that risk.

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Step-Up Bonds (The Hidden Asymmetry)

Step-up bonds start with a lower coupon that increases at predetermined intervals. A typical structure might pay 4% for years 1-2, stepping up to 5% for years 3-4, then 6% for years 5-10.

The appeal: Higher coupons later in the bond's life, compensating for reinvestment uncertainty.

The catch: Step-up bonds almost always include call provisions at each step-up date. The issuer can redeem the bond at par when the coupon steps up.

The asymmetry problem:

• If rates fall: Issuer calls the bond at the step-up date (you don't get the higher coupon)
• If rates rise: Issuer doesn't call (you're stuck with a below-market coupon until the next step)

The point is: you rarely capture the highest step-up coupon. Issuers call when it benefits them, not you. The promised "reward for patience" often doesn't materialize.

Evaluation rule: Analyze step-up bonds using yield-to-worst (assuming earliest call), not yield-to-maturity. If the yield-to-worst doesn't compete with comparable fixed-rate bonds, the step-up structure isn't adding value—it's adding issuer optionality at your expense.

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Side-by-Side Comparison (Choosing the Right Structure)

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Common Mistakes (What Costs You Money)

Mistake 1: Buying fixed at rate cycle peaks

If rates are at multi-decade highs, fixed-rate bonds lock in attractive income. But if you bought fixed-rate bonds in 2021 (when rates were near zero), you suffered the worst bond market losses in decades when rates normalized.

The fix: Consider your rate outlook. Fixed-rate bonds are a bet that current rates are good. If you have no rate view, split allocation between fixed and floating.

Mistake 2: Ignoring the spread on floaters

A SOFR + 50 bps note versus SOFR + 150 bps means 1% less annual income ($1,000 per $100,000) for the entire life of the note. Some investors grab the "higher quality" tight-spread note without calculating the income sacrifice.

The fix: Compare spreads at similar credit ratings. An A-rated issuer at SOFR + 100 bps may be better value than an AA-rated issuer at SOFR + 40 bps (if you're compensated for the incremental risk).

Mistake 3: Expecting step-ups to reach terminal coupon

Investors mentally anchor on the highest step-up rate and forget that issuers will call the bond if that rate exceeds market alternatives.

The fix: Always evaluate yield-to-worst. If the step-up is only attractive at yield-to-maturity, you're betting on a scenario that benefits you—which means the issuer will likely prevent it.

Mistake 4: Treating floaters as "safe" in all dimensions

Floating-rate eliminates interest rate risk but does nothing for credit risk. In 2022, bank loan losses came from credit deterioration (defaults, downgrades), not from rate sensitivity.

The fix: Separate rate risk from credit risk. A high-yield floater still carries substantial default risk regardless of its near-zero duration.

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Decision Framework (Matching Structure to Situation)

Choose fixed-rate when:

• You believe current rates are attractive relative to history
• You're holding to maturity and want predictable income
• You're immunizing liabilities with known cash flow needs
• You expect rates to fall (capturing price appreciation plus locked-in income)

Choose floating-rate when:

• You expect rates to rise (or remain volatile)
• You need principal stability (low tolerance for price swings)
• You're uncertain about rate direction but want income
• You're building a short-duration portfolio segment

Avoid step-ups unless:

• Yield-to-worst is competitive with comparable fixed-rate alternatives
• You've explicitly priced the call option you're granting the issuer
• The step-up schedule offers meaningful compensation for call risk

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Worked Example (The 2024 Allocation Decision)

Your situation: $100,000 bond allocation, 3-year holding period, uncertain rate outlook.

Option A: 5% fixed-rate corporate bond

• Income: $5,000/year (certain)
• If rates rise 1%: price falls roughly 4.5% (duration 4.5 years)
• Year 1 total return if rates rise: $5,000 income - $4,500 price loss = $500

Option B: Corporate FRN at SOFR + 150 bps

• Current income: $5,800/year (at SOFR 4.30%)
• If rates rise 1%: income rises to ~$6,800, price unchanged
• Year 1 total return if rates rise: $5,800-$6,300 (depending on timing of reset)

Option C: Step-up starting at 4%, stepping to 5.5% in year 2

• Year 1 income: $4,000
• If rates fall: likely called before reaching 5.5%
• If rates rise: you're below-market until step-up date

The practical takeaway: In uncertain rate environments, floaters provide both competitive income and price stability. Fixed-rate bonds require a directional view. Step-ups require favorable conditions that often don't materialize.

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Next Step (Put This Into Practice)

Check the coupon structure of your current bond holdings. For each bond or fund:

1. Identify the coupon type (fixed, floating, or step-up)
2. Note the duration (rate sensitivity)
3. For floaters: identify the reference rate and spread
4. For step-ups: calculate yield-to-worst (not yield-to-maturity)

Interpretation:

• High fixed-rate allocation + short expected hold = vulnerable to rate rises
• High floater allocation + falling rate expectation = income will decline
• Step-ups evaluated at yield-to-maturity = you're probably overpaying

Action: If your bond allocation doesn't match your rate outlook (or you have no rate view), consider diversifying across coupon structures. A mix of fixed and floating provides natural hedging against rate uncertainty.

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References

• Morningstar. 2024. "Fixed Versus Floating: The Great Income Debate."
• SIFMA. 2024. "SOFR Primer." Securities Industry and Financial Markets Association.
• VanEck. 2024. "Protect Against Fed Rate Hikes with Floating Rate Notes."
• Treasury Direct. 2024. "Floating Rate Notes."
• Federal Reserve Bank of New York. 2024. "Secured Overnight Financing Rate Data."
• Raymond James. 2024. "Step-Up Bonds: Types of Fixed Income."
• World Bank. 2024. "World Bank Prices 4-Year SOFR Index-Linked Floating Rate Bond."
• Charles Schwab. 2024. "Floating-Rate Notes: 4 Key Considerations."