Preparing for CFA?

Practice tests, mock exams and readings with performance analytics. More Info

Home
AlphaBetaPrep.com
Sign In

Structure of bond cash flows

The most common bond cash flow structure is that of a conventional (plain vanilla) bond, regular fixed coupon payments and a single principal repayment at the maturity date. Even though bonds in a single category have similar cash flow structure, there is considerable variation between different bond types.

Principal repayment structures

The timeline of principal repayment of bonds is important because it affects its credit risk. Bonds that return at least some principal over their life have lower credit risk.

Bullet, amortized and partially-amortized bonds

A bullet bond is a bond that pays the whole par value at the maturity date. For example, a 5-year bond with a par value of $1,000 and an annual coupon of 6% will pay $60 in annual coupons for four years and a $1,060 as a final payment (which is the sum of the last coupon of $60 and principal repayment of $1,000).

An amortizing bond is a bond that pays equal periodic payments (of interest and principal) over the life of the bond such as the principal is repaid completely by the maturity date. Such a bond effectively forms an annuity. The equal periodic payments can be determined using the formula for finding PMT in a time value of money problem. The principal repayment in each period equals the difference between the fixed periodic period and interest accrued in that period.

A partially-amortizing bond is a bond that pays some of the principal together with regular coupon payments and some it through a balloon payment at the maturity date.

Sinking fund arrangement

A sinking fund arrangement obligates the bond issuer to repurchase a portion of bonds each period. Historically, a sinking fund provision requires establishment of a fund to which the issuer deposited the necessary funds needed to retire the required number of bonds, but recently sinking fund provision just requires retirement of a pre-specified portion of outstanding bonds regardless of whether cash reserve is created.

An issuer typically sends the funds to the trustee who selects bonds randomly based on their serial numbers. A variant of sinking fund arrangement requires redeeming a steadily increasing amount of bond’s notional principal. Another variant replaces the sinking fund with a call provision that entitles bond issuer to buy back bonds at the minimum of par, market value or sinking fund value to the extent of a small proportion of total bonds outstanding.

Advantages of sinking fund arrangement

The main advantage of sinking fund arrangement is that it reduces the credit risk, but it exposes bondholders whose bonds are selected for retirement to reinvestment risk because they receive cash flows when they do not have readily available new investment opportunities. Another disadvantage is that the issuer may be able to buy the bonds back at par when their market price is greater than par.

Coupon payment structures

A conventional bond pays fixed coupon payments at a specified frequency per year till the maturity date. Semi-annual coupons are common in the case of sovereign and corporate bonds, particularly in the US and the Commonwealth countries. Eurobonds and bonds in eurozone typically pay annual coupons.

Floating rate note

A floating-rate note (FRN) pays coupon payments which fluctuate in lien with some reference rate. FRNs are typically issued by government-sponsored agencies and they pay quarterly coupons. Typically, an FRN coupon rate is the sum of a variable reference rate such as LIBOR plus a fixed spread. Bonds in which both the reference rate and the spread are variable are called variable-rate notes. Some FRNs have a cap i.e. a maximum limit on the coupon rate which favors the issuers while some have a floor, i.e. a rate below which the coupon rate cannot fall which benefits the bondholders. Further, some FRN have both a cap and floor, these are called collared FRN.

An inverse FRN or reverse floater has a coupon rate which changes opposite to any change in the reference rate.

FRN have lower interest rate risk than traditional bonds because their interest rate changes in response to changes in market interest rates. Investors prefer FRN if they expect interest rates to rise. FRN trades at par value but may deviate if there is a change in the perceived credit risk of the bond.

Step-up coupon bond

A step-up coupon bond is a bond, either fixed or variable, whose spread increases incrementally over the life of the bond. Bonds with step-up coupons offer protection against rising market interest rates. It is because when market interest rates increase, the bond’s coupon rates also increase thereby limiting any decrease in bond value.

A step-up coupon structure is an important feature of callable bonds because it provides an incentive to the issuer to call bonds when their coupon rate rises. However, such a call is not guaranteed because an issuer’s circumstances may be such that it might not be able to issue new bonds at lower spread due to its deteriorated credit quality.

Credit-linked coupon bond

A credit-linked coupon bond is a bond whose coupon rate changes in response to any change in its credit rating. Such a bond is attractive to bondholders because it offers increased compensation if the issuer’s credit quality declines and also provides a hedge against recessionary pressures. However, such compensation may prove inadequate because an adjustment in coupon might trigger a further rating downgrade and possibly default.

Payment-in-kind coupon bond

A payment-in-kind coupon bond is a bond that allows the issuer to pay interest in the form of new bonds instead of cash. They are attractive to issuers who expect that they might run into cash flow problems, but since investors know about the increased credit risk, they require high yield on such bonds. Some PIK bonds may pay interest in an equivalent number of common shares. In a PIK toggle note, the issuer has an option to decide whether it wants to pay interest in cash or kind.

Deferred-coupon bond

A deferred-coupon bond (also called a split-coupon bond) is a bond that does not pay any coupon in the early years of its term but pays a higher coupon rate subsequently. Such a bond is useful for companies who want to conserve cash initially or in project financing when an asset is being developed and positive net cash flows are not yet available. Such bonds are typically issued at a discount to par and may have tax advantages.

Index-linked bonds

An index-linked bond is a bond whose coupon and/or principal payments are linked to an index of earnings, currencies, commodities, etc. Inflation-linked bonds are bonds that are linked to a measure of inflation such as CPI (or RPI in the UK).

The advantage of using CPI and/or RPI has an index is that they are transparent and regularly published. Governments are large issuers of inflation-linked bonds called linkers. US Treasury issues Treasury inflation-protected securities (TIPS). Recently, the corporate sector has been issuing inflation-linked bonds more frequently.

A conventional bond pays nominal interest rate but since the purchasing power of money decreases as a consequence of inflation, the real interest rate equals the excess of nominal interest rate over the inflation rate. Inflation-linked bonds reduce inflation risk by causing the coupon and/or principal payments to adjust in response to a change in purchasing power.

Motivations for issuing index-linked bonds

Governments issue inflation-linked bonds due to either of the three motives:

  • Their economies are experiencing very high inflation and without inflation protection, no one would invest in their bonds. Historical examples includes Brazil, Chile, and Columbia.
  • They want to signal their dis-inflationary policies and to capitalize on the demand for inflation-protection. Examples include the UK, Australia, and Sweden.
  • For the social welfare benefits of low inflation (US, Canada, Germany, etc.)

Methods of bond indexation

Different methods are adopted to link coupon and/or principal payments:

  • Zero-coupon-indexed bonds do not pay any coupons, but their principal is adjusted for inflation.
  • Interest-indexed bonds adjust only the coupon payment for inflation but not principal.
  • Capital-index bonds adjust the face value of the bond for inflation which results in inflation-linked coupon payments and principal repayment.
  • Indexed-annuity bonds are fully amortizing annuity bonds which are adjusted for inflation.

by Obaidullah Jan, ACA, CFA on Mon Feb 17 2020

This article can help you prepare for Reading 42 LOSe.

Access complete notes and question bank   Login with Google Login with Facebook


More Articles

Contents of a bond indenture Affirmative vs negative bond covenants Structure of bond cash flows Bonds with contingency provisions