IFT Notes for Level I CFA^{®} Program
R42 FixedIncome Securities: Defining Elements
Part 4
4. Structure of a Bond’s Cash Flows
Not all bonds are structured to make periodic interest payments and one lumpsum principal payment at the end. In this section we will look at the different ways in which principal and interest can be paid over the bond’s life.
4.1. Principal Repayment Structures
Bullet bond: The principal is paid all at once at maturity. Such a type of bond is called a bullet bond.
Bullet Bond: Payment Structure for a 5year, $1000 Bond with 6% Coupon Paid Annually 
Year 
Cash flow in $ 
Interest Payment
(in $) 
Principal Repayment
(in $) 
Outstanding principal
(in $) 
0 
1,000 


1,000 
1 
60 
60 
0 
1,000 
2 
60 
60 
0 
1,000 
3 
60 
60 
0 
1,000 
4 
60 
60 
0 
1,000 
5 
1000 + 60 = 1060 
60 
1,000 
0 
Key points to be noted for a bullet bond (based on the table above):
 No part of the principal is paid before maturity. The $1,000 amount towards principal is paid all at once at maturity.
 During the life of the bond, the principal remains outstanding.
 The last payment includes both the coupon payment of $60 and principal payment of $1,000.
Fully amortized: A fully amortized bond is one in which the principal is paid little by little in equal payments over the bond’s life, so that it is repaid in full by the maturity date. The periodic payments made by the issuer consist of interest and a part of principal as shown for a sample bond in the table below.
Fully Amortized Bond: Payment Structure for a 5year, $1,000 Bond with 6% Coupon Paid Annually, market interest rate = 6% 
Year

Investor cash flows in $
a = b + c 
Interest Payment
(in $)
b 
Principal Repayment
(in $)
c 
Outstanding principal
(in $)
P_{t1}c 
0 
1,000 


1,000 
1 
237.40 
60 
177.4 
822.6 
2 
237.40 
49.36 
188.04 
634.56 
3 
237.40 
38.07 
199.32 
435.24 
4 
237.40 
26.11 
211.28 
223.96 
5 
237.40 
13.44 
223.96 
0 
Partially amortized: A partially amortized bond is one in which only a part of the principal is repaid over the bond’s life. The remaining big part of the principal is paid at maturity making it a balloon payment. This is a hybrid between the bullet and the fullyamortized bond. The table below shows a sample bond.
Partially Amortized Bond: Payment Structure for a 5year, $1,000 Bond with 6% Coupon Paid Annually 
Year 
Investor cash flows
(Coupon)
in $ 
Interest Payment
(in $) 
Principal Repayment
(in $) 
Outstanding principal
(in $) 
0 
1,000 


1,000 
1 
201.92 
60 
141.92 
858.08 
2 
201.92 
51.48 
150.43 
707.65 
3 
201.92 
42.46 
159.46 
548.19 
4 
201.92 
32.89 
169.03 
379.17 
5 
401.92 
22.75 
379.17 
0 
Sinking Fund Arrangements
Sinking fund arrangement: This allows for full or partial amortization of a bond prior to its maturity. It specifies the portion of the bond’s principal outstanding that must be repaid each year throughout the bond’s life.
Three sinking fund arrangements:
 Standard: Issuer sends the repayment principal amount to the trustee. The trustee then either redeems bonds to this value or decides which bonds to retire through a lottery.
 Accelerated: Issuer retires more than the specified portion of the bond’s notional principal. The amount redeemed steadily increases each year. If there is any remaining principal, it is redeemed at maturity.
 Call provision: Bonds with call provision give the issuer the right to call (repurchase) the bond before maturity. Callable bonds usually have higher yields as investors bear the risk that they may be called. It is beneficial to the issuer and disadvantageous to the bondholder. The bonds to be retired are selected randomly.
A sinking fund arrangement results in
 Lower credit risk: The objective of a sinking fund provision is to reduce credit risk for investors because the issuer does not have to pay a large payment at maturity. From an investor’s perspective, there is less credit risk as the principal is being paid over the bond’s term.
 Higher reinvestment risk: Receiving principal payments before maturity also means the investor has to bear reinvestment risk, i.e., if the money received cannot be invested at the same or higher expected return. In a declining interest rate environment, there is a risk of investing the proceeds at a lower rate.
4.2. Coupon Payment Structures
Fixed periodic coupons
 This is the most basic form of coupon payment. A fixed interest is paid either semiannually or annually.
Floatingrate notes (FRN)
 A bond whose coupon is set based on some reference rate plus a spread.
 FRNs can have floors (minimum interest rate), caps (maximum interest rate), or collars (both a minimum and maximum rate).
 An inverse FRN is a bond whose coupon has a negative relationship with the reference rate.
Other coupon structures
 Stepup coupons: Coupons increase by specified amounts on specified dates.
 Bonds with creditlinked coupons: Coupons change when the issuer’s credit rating changes.
 Bonds with paymentinkind coupons: Issuer can pay coupons with additional amounts of the bond issue instead of cash.
 Bonds with deferred coupons: No coupons paid in the initial years but higher coupons paid later.
 Indexlinked bonds: Coupon payments and/or principal repayments are linked to a price index, i.e., inflationlinked bonds. Examples of inflationlinked bonds include the following:
 Zerocouponindexed bonds: The inflation adjustment is made via the principal repayment only.
 Interestindexed bonds: An indexlinked coupon is paid during the bond’s life but nominal principal amount at maturity is fixed. This is essentially a floatingrate note in which reference rate is the inflation rate instead of a market rate such as Euribor.
 Capitalindexed bonds: Fixed coupon rate is paid but it is applied to a principal amount that increases in line with increases in the index during the bond’s life.
 Indexedannuity bonds: The annuity payment, which includes both payment of interest and repayment of the principal, increases in line with inflation during the bond’s life. These are fully amortized bonds, unlike interestindexed and capitalindexed bonds that are nonamortizing coupon bonds.
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