How are step-up coupon bonds accounted for on the issuer's books?

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AcadiFi · Accepted Answer

Step-up coupon bonds are plain-vanilla debt instruments with contractually scheduled coupon increases. Unlike increasing-rate preferred, step-up debt uses a single effective interest rate (the internal rate of return on all contracted cash flows given the issue price) applied over the entire life of the bond.

Example — Stellaris Logistics issues $300M of 10-year notes at par. Coupons are 3% (semi-annual) in years 1-5 and 7% in years 6-10.

Step 1: Solve for the yield to maturity that equates PV of all coupons and principal to $300M proceeds. Call it 4.92% semi-annual compounded.

Step 2: Each period, interest expense equals 4.92% × beginning carrying value. In early years this exceeds the 3% cash coupon, so carrying value accretes upward. In later years it sits below the 7% coupon, so carrying value amortizes back toward face.

Year 1 Period 1:
- Beginning CV: $300.0M
- Interest expense: 2.46% × $300M = $7.38M
- Cash coupon paid: 1.5% × $300M = $4.50M
- Accretion: $2.88M → new CV $302.88M

Year 6 Period 1 (CV has risen to roughly $322M before reversing):
- Interest expense: 2.46% × $322M = $7.92M
- Cash coupon: 3.5% × $300M = $10.5M
- Amortization: reduces CV by $2.58M

The straight-bond nature means all amounts hit the income statement as interest, not dividends, and the effective interest method is mandatory under both IFRS 9 and US GAAP. Tax deductibility and DSCR ratios should use interest expense rather than cash coupons for accuracy.

How are step-up coupon bonds accounted for on the issuer's books?

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