101 Concepts for the Level I Exam
Concept 79: Cash Flows of Fixed-Income Securities
Bullet structure: Pays coupon periodically and entire payment of principal occurs at maturity.
- An amortizing bond is a bond that repays part of its principal at each payment date.
- For a fully amortized bond, the amortizing bond’s outstanding principal amount is reduced to zero by the maturity date.
- However, for a partially amortizing bond, a balloon payment is required at maturity to repay the remaining principal as a lump sum.
Sinking fund agreements: Here the issuer is required to retire a portion of the bond issue at specified times during the bond’s life.
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.