Reading 48: Fixed-Income Cash Flows and Types

Book 3: Fixed Income

Bullet Structure

principal is paid back in a single payment maturity and interest payments are made periodically

Amortizing Loan

loan structure in which periodic payments include both interest and principal

Fully Amortizing Loan

the principal is fully paid off when the last periodic payment is made

How are the interest and principal portions of periodic payments affected as the maturity date approaches for a Fully Amortizing Loan?

interest portion => decreases

principal portion => increases

the amount of principal decreases over time and therefore the coupon payment decreases. the same periodic payment value still stays constant, thus, more has to come from the principal

Partially Amortizing Loan

there is a repayment of some principal at maturity

Balloon Payment

the amount of remaining principal to be paid at maturity

How much interest is in a final balloon payment?

none

Sinking Fund Provision

after a specified period of time, at random, there is repayment of principal through a series of payments over the life of the issue

some bondholders get the full redemption at various points throughout maturity

What is the disadvantage of a sinking fund provision?

reinvestment risk

there is a chance that when an investor gets his full principal repayment that interest rates will be low and the amount to reinvest won’t be better than the original bond that he was in

Waterfall Structure

establishes principal repayments by splitting seniority into tranches

What are Waterfall Structures specifically used in?

ABS and MBS

True or False: only principal is allocated on a Waterfall Structure basis to the most senior obligations first, while interest is paid to everyone.

true

What is the typical coupon payment of floaters?

quarterly coupon reference rate + fixed margin

Step-Up Coupon Bonds

the coupon rate increases over time according to a predetermined schedule or a potential future event

What are examples of Step-Up Coupon Bonds?

Leveraged Bonds ==> if the credit quality of the issuer deteriorates, the coupon increases

• specifically for issuers already in poor credit standing

Credit-Linked Note ==> the coupon rate of the issuer’s credit rating falls

Payment in Kind Bonds (PIK)

issuer makes coupon payments by increasing the principal amount of the outstanding bonds

paying bond interest by issuing new bonds

Green Bonds

coupon increases if certain ESG requirements are not met

Indexed-Linked Bonds

coupon payments or a principal amount is based on a specific index

What is the most common type of Indexed-Linked Bond?

Inflation-Linked Bond

Inflation-Linked Bond

increases cash flows in line with an inflation index

Types of Inflation-Linked Bonds

Interest-Indexed Bonds

Capital Indexed Bonds

Interest-Indexed Bonds

coupon rate is adjusted for inflation while principal remains unchanged

Capital-Indexed Bonds

coupon rate remains unchanged while the principal value is adjusted for inflation

most common

TIPS

Which option gives investors full protection against inflation—Interest-Indexed Bonds or Capital-Indexed Bonds?

capital-indexed

the principal amount is adjusted, and implicitly the coupon rate is also adjusted because coupon’s are derived from the par value

What kind of bond is best minimizing reinvestment risk?

zero-coupon bond

Deferred Coupon Bond

regular coupon payments do not begin until a specified time after issuance

zero-coupon

Contingency Provision

in an indenture, an action that may be undertaken if an event the contingency actually occurs

embedded options

Types of Embedded Options

callable bonds

putable bonds

convertible bonds

Callable Bonds

gives the issuer the right to redeem all or part of a bond at a predetermined fixed price

Callable Protection

the time period in which bonds cannot be called

What actions can induce a Callable Bond be called?

interest rates fall or the credit quality of the issuer increases

What price can a callable bond not exceed in the market?

the call price

Value of a Call Option =

price of callable bond – price of an identical noncallable bond

Putable Bond

gives the lender the right to sell the bond back to the issuing company at a prespecified price, typically at par

What actions can induce a putable bond to be sold?

when interest rates rise or the credit quality of the issuer to fall

Value of a Putable Bond =

price of an identical putable bond – price of a putable bond

Convertible Bond

gives the bondholder the right to exchange the bond for specific number of common shares

Conversion Price

the par amount per share at which the bond may be converted

Conversion Ratio

the par value divided by the conversion price

Conversion Value

the market value of the shares that would be received upon conversion

Warrants

gives the holder the right to buy the firm’s common shares at a fixed price over a given period

Ex of a warrant

warrant of $40 means shareholders can buy shares at $40 if the share price has exceeded $40

Contingent Convertible Bonds (CoCos)

bonds that convert from debt to common equity automatically if a specific event occurs

How are CoCo’s beneficial for banks?

it decreases the amount of interest-bearing liabilities on their balance sheet while simultaneously increasing equity

Domestic Bonds

bonds of issuers domiciled in the same country as the market in which the bonds are issued and traded

Foreign Bonds

bonds from issuers from countries other than the market in which the bond trades

Example of a UK Foreign Bond

UK bond issued in $ issued in US

Eurobonds

issued outside the jurisdiction of any one country and can be issued in any currency

Which is subject to more regulation—domestic bonds or eurobonds?

domestic bonds

Ex of a euroyen bond

Chinese firm issues yen denominated bonds outside Japan

Global Bonds

eurobonds that trade in at least one domestic market and in the eurobond market

Bearer Bond Form

a bond that is not issued to any owner’s name, and instead, ownership is proven by possessing the bond

what eurobonds used to trade in

Registered Bond Form

a record of ownership is required

International Bond

foreign bonds, global bonds, and eurobonds that involve more than one country

Sukuk Bonds

Sharia-compliant bonds

periodic payments are considered to be cash flows from rent on underlying assets

How is fixed-coupon taxed?

interest income paid to bondholders is taxed as ordinary income

How are muni bonds taxed?

tax exempt at the federal level and tax exempt at the state level if owned in the same state as the muni bondW

When a bond is sold at a gain or loss, how is it taxed?

capital gains

Original Issue Discount Bonds (OID)

bonds sold at a significant discount to par when issued

they are still taxed as ordinary income as the gain in value happens even though there is no cash outlays because the value approaches par over the life of the bond