Fixed-Income Cash Flows and Types

Introduction

This module explores the diverse cash flow structures of fixed-income instruments and the legal, regulatory, and tax considerations that impact them. Understanding these aspects is crucial for properly valuing bonds and assessing their risks.

Fixed-Income Cash Flow Structures

Bonds can be structured to pay back principal and interest in many different ways.

Structure Type	Description & Cash Flow Pattern	Key Considerations
Bullet Bonds	The issuer pays periodic interest (coupons) throughout the bond's life and repays the entire principal amount in a single "bullet" payment at maturity.	This is the most common and simplest structure, preferred for its predictable and stable cash flows.
Amortizing Debt	The issuer repays parts of the principal outstanding over the life of the bond, along with interest payments. Fully Amortizing: Each payment is equal and covers both interest and a portion of the principal (like a mortgage). Partially Amortizing: Involves periodic principal repayments, but a large lump sum (a balloon payment) is still due at maturity.	Benefits: Reduces credit risk for the investor over time as the principal is repaid. Risks: Exposes investors to reinvestment risk, as they receive principal back earlier and must reinvest it, potentially at lower interest rates.
Sinking Funds	A provision requiring the issuer to set aside funds to gradually repay a portion of the bond principal before maturity. This is a form of amortization designed to reduce credit risk.	Lowers the credit risk of the bond but, like amortizing debt, introduces reinvestment risk for the bondholder.
Floating-Rate Notes (FRNs)	The coupon payments are not fixed. Instead, they are based on a market reference rate (like LIBOR or SOFR) plus a fixed credit spread. The coupon rate resets periodically.	Benefits: Reduces interest rate risk for the investor, as coupon payments adjust to market conditions. Risks: Credit risk remains a key factor.
Special Coupon Structures	Step-Up Coupon Bonds: The coupon rate increases at predetermined dates. Credit-Linked Coupon Bonds: The coupon rate adjusts based on changes in the issuer's credit rating. Payment-in-Kind (PIK) Bonds: Allows the issuer to pay interest with additional bonds rather than cash. Index-Linked Bonds: Coupon payments are linked to an inflation index, protecting investors from inflation risk.	These structures are designed to offer specific protections or incentives to investors, often in exchange for a lower initial yield.
Zero-Coupon & Deferred Coupon Bonds	Zero-Coupon Bonds: Issued at a deep discount to face value, make no periodic interest payments, and pay the full face value at maturity. Deferred Coupon Bonds: Interest payments are delayed for a specified period at the beginning of the bond's life.	Zero-coupon bonds offer complete protection against reinvestment risk since there are no coupons to reinvest. Deferred coupon bonds may indicate higher risk or specific financing needs of the issuer.

Fixed-Income Contingency Provisions (Embedded Options)

Contingency provisions are options embedded within a bond that can be exercised if certain conditions are met. They fundamentally alter a bond's risk and return profile.

Provision Type	Who Holds the Option?	Description	Impact on Bond Price & Yield
Callable Bonds	Issuer	Gives the issuer the right to redeem (or "call") the bond before its scheduled maturity date at a predetermined price. Issuers do this when interest rates fall, allowing them to refinance their debt at a lower cost. Call Protection Period: A period after issuance when the bond cannot be called. Make-Whole Call: A type of call provision that compensates bondholders based on the present value of future payments, making it less disadvantageous for them.	Because the call option benefits the issuer, callable bonds are issued at a lower price and offer a higher yield compared to identical non-callable bonds to compensate investors for the call risk.
Putable Bonds	Bondholder	Gives the bondholder the right to sell the bond back to the issuer before maturity at a predetermined price. Bondholders do this when interest rates rise, allowing them to reinvest their capital at higher rates.	Because the put option benefits the bondholder, putable bonds are issued at a higher price and offer a lower yield compared to identical non-putable bonds.
Convertible Bonds	Bondholder	Gives the bondholder the right to convert the bond into a predetermined number of common shares of the issuer's stock. Convertible Bond = Option-Free Bond + Equity Call Option	Convertible bonds offer a lower yield than non-convertible bonds because the conversion feature provides potential upside from the company's stock performance.
Contingent Convertible Bonds (CoCos)	Issuer (Automatic)	These bonds automatically convert into common stock if a specific trigger event occurs, such as the issuer's (typically a bank's) capital ratio falling below a certain level.	CoCos reduce the issuer's default risk during downturns but force losses onto bondholders. They typically offer a higher yield to compensate for this forced conversion risk.

Legal, Regulatory, and Tax Considerations

The environment in which a bond is issued and traded significantly affects its characteristics and the after-tax return for investors.

Legal and Regulatory Considerations

The primary markets for bonds are often categorized by their jurisdiction.

Domestic Bonds: Issued in a country by an entity incorporated in that country and denominated in the local currency.
Foreign Bonds: Issued in a country by an entity incorporated in another country, but still in the local currency (e.g., a "Yankee bond" is a USD bond issued in the U.S. by a non-U.S. company).
Eurobonds: Issued and traded outside the jurisdiction of any single country and are often less regulated. They can be issued in any currency and are typically unsecured bearer bonds.
Global Bonds: Bonds that are issued simultaneously in the Eurobond market and at least one domestic market, ensuring wide distribution for very large issues.

Tax Considerations

For Corporate Issuers: Interest expenses are generally tax-deductible, making debt an attractive source of financing.
For Investors: The tax treatment of bond income varies significantly by jurisdiction and bond type:
- Interest Income: Often taxed at the investor's ordinary income tax rate.
- Capital Gains/Losses: The tax treatment of gains or losses from selling a bond can differ, with long-term gains often taxed at a lower rate.
- Zero-Coupon Bonds: The implied interest (original issue discount or OID) may be taxed annually even though no cash is received until maturity.