IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

# Part 4

## 4.  Structure of a Bond’s Cash Flows

Not all bonds are structured to make periodic interest payments and one lump-sum 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 5-year, $1000 Bond with 6% Coupon Paid Annually Year Cash flow in$ 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 5-year, $1,000 Bond with 6% Coupon Paid Annually, market interest rate = 6% Year Investor cash flows in$ a = b + c Interest Payment (in $) b Principal Repayment (in$) c Outstanding principal (in $) Pt-1-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 fully-amortized bond. The table below shows a sample bond.  Partially Amortized Bond: Payment Structure for a 5-year,$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 semi-annually or annually.

Floating-rate 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

• Step-up coupons: Coupons increase by specified amounts on specified dates.
• Bonds with credit-linked coupons: Coupons change when the issuer’s credit rating changes.
• Bonds with payment-in-kind 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.
• Index-linked bonds: Coupon payments and/or principal repayments are linked to a price index, i.e., inflation-linked bonds. Examples of inflation-linked bonds include the following:
• Zero-coupon-indexed bonds: The inflation adjustment is made via the principal repayment only.
• Interest-indexed bonds: An index-linked coupon is paid during the bond’s life but nominal principal amount at maturity is fixed. This is essentially a floating-rate note in which reference rate is the inflation rate instead of a market rate such as Euribor.
• Capital-indexed 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.
• Indexed-annuity 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 interest-indexed and capital-indexed bonds that are non-amortizing coupon bonds.