Fixed-Income Cash Flows and Types Flashcards
What is a bullet bond?
The bond issuer receives the principal at settlement, makes periodic, fixed coupon payments, and repays the principal at maturity.
Most government and corporate issuers use bullet bonds as their primary means of debt financing, and investors often prefer the associated fixed income stream and set maturity to fund known cash flows.
What is amortizing debt?
Fixed-income instruments that periodically retire a portion of principal outstanding prior to maturity offer a borrower the ability to spread payments more evenly over the life of the instrument. Examples include commercial or residential real estate mortgage loans. Investors receive higher near-term cash flows on this amortizing debt relative to bullet bonds and face lower credit risk because the borrower’s liability is reduced over time. However, investors also face the risk of reinvesting the higher cash flows at prevailing market interest rates over the life of the instrument, which could decline.
What is a lump sum or balloon payment?
A lump sum or balloon payment is a large, one-time payment made at the end of a loan term or financial agreement, typically after smaller periodic payments. It is common in mortgages, auto loans, and commercial financing.
How to calculate the periodic payment A?
r * principal / 1 - (1 + r)^ -N
What is a sinking fund arrangement?
Used by issuers to periodically retire a bond’s principal outstanding. The term sinking fund refers to an issuer’s plans to set aside funds over time in an escrow account to retire the bond early based on terms agreed upon issuance.
What is a waterfall structure?
This approach is used to determine the timing of cash flows to investor classes (tranches) with different priority claims to the same cash flows. In the most common form, interest or coupon payments are paid to all classes with no preference, but the repayment of principal occurs sequentially so that the most senior investor class with the highest ranking in the capital structure receives principal payments first, followed by the second-highest ranked investors once the most senior class has been fully repaid.
Think of MBS tranches! Payment shortfalls are borne by the more junior tranches since senior tranches are paid first.
What are variable interest debts?
Some bonds and most loans have variable interest payments, calculated using a market reference rate (MRR) and a credit spread. Financial intermediaries prefer floating-rate loan assets since they match their variable-rate liabilities, such as deposits. Loans or floating-rate notes are also attractive to investors seeking to benefit from rising interest rates.
FRN Coupon = MRR + Credit Spread
What are step-up bonds?
In case of predetermined adjustments, a bond coupon increases by specified margins at specified dates. They are used to protect investors against rising rates and, in some cases, to provide an incentive for issuers to take advantage of a contingency provision.
What are index-linked bonds?
Bonds that have interest and/or principal payments linked to a specified index. Although a bond may be linked to any variable, in practice, inflation-linked bonds tied to a broad consumer price index are by far the most common type of index-linked bonds.
What is a contingency provision?
A clause in a legal agreement that allows for an action if an event or circumstance occurs. The most common contingency provisions for bonds involve the right - but not the obligation - for an issuer or the bondholders to take an action specified in an indenture.
What are the three most common bonds with contingency provisions?
Callable bonds
Putable bonds
Convertible bonds
What is a callable bond?
An issuer of a callable bond has the right to redeem all or part of the bond prior to the specified maturity date. An issuer considering callable versus non-callable bonds usually seeks the flexibility to refinance debt if market interest rates were to fall. Fixed-price calls grant an issuer the right to buy back the bond at a predetermined price in the future.
Callable bonds typically specify a period over which the call feature cannot be used, known as a call protection period.
How does the relationship between YTM and the coupon rate affect the call feature’s value?
If YTM is higher than the coupon rate, the issuer has no incentive to call the bond. If YTM is lower than the coupon rate, the bond is likely to be called, limiting its price appreciation.
Why would an issuer call a bond when YTM falls below the coupon rate?
The issuer can refinance at a lower interest rate by calling the bond and issuing a new one with a lower coupon.
What happens to the price of a callable bond when YTM is above the coupon rate?
The callable bond behaves like a non-callable bond because the call feature has little value in this scenario.
What happens to the price of a callable bond when YTM is below the coupon rate?
The bond’s price is effectively capped at the fixed call price because investors anticipate it being called.
How does a non-callable bond’s price respond to falling interest rates compared to a callable bond?
A non-callable bond’s price continues to rise as interest rates drop, while a callable bond’s price is capped at the call price.
Why do callable bonds typically offer higher coupon rates than non-callable bonds?
To compensate investors for the risk that the bond may be called, limiting their potential price appreciation. It is called call risk.
Why would an issuer not call a bond when YTM is above the coupon rate?
Because the interest rates are higher, the issuer must offer higher coupon rates to attract investors. That means that refinancing is more expensive than keeping the current callable bond.
What are putable bonds?
A put provision gives bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates. The put price is usually the par value of the bond. Putable bonds benefit bondholders by guaranteeing a pre-specified selling price at the redemption dates. If interest rates rise after issuance and bond prices fall, bondholders can sell the bond back to the issuer and reinvest the proceeds at higher market interest rates.
Since a put provision has value to bondholders, the price of a putable bond will be above the price of an otherwise similar non-putable bond. The yield on a bond with a put provision must therefore be lower than the yield on an otherwise similar non-putable bond.
What is a convertible bond?
A debt instrument with a contingency provision related to the issuer’s outstanding common equity. It grants bondholders the right to exchange the issuer’s bond for a number of its common shares in the future at an effective price per share known as the conversion price.
What is the conversion ratio?
The number of common shares a bond may be converted into for a specific par value.
What is the conversion value?
Conversion ratio * current share price
The use of convertible debt is common among growth companies, which may have limited cash flow to pay interest and repay principal but are willing to raise equity at a higher conversion price in the future.
What is a warrant?
A warrant is an “attached”, rather than embedded, option entitling the bondholder to buy the issuer’s stock at a fixed exercise price until the expiration date.
Fixed-income securities are subject to different legal and regulatory requirements depending on where they are issued and traded, as well as who holds them.
Based on the jurisdictions of the issuer and the issuance, a bond can be classified as a domestic, foreign, or Eurobond.
What are domestic and foreign bonds?
Domestic bonds are issued by entities incorporated in the same country.
Foreign bonds are issued by entities incorporated in another country.
In frontier markets, domestic bond issuance usually comprises domestic sovereign bonds and bonds of local financial intermediaries, such as banks. Corporate debt financing usually takes the form of a bank loan in these markets, and investors are limited to indirect fixed-income exposure to corporate issuers via bank bond purchases.
What are Eurobonds?
Eurobonds are debt instruments issued in a currency different from the country of issuance. They are usually unsecured and underwritten by a group of financial intermediaries from different jurisdictions.
What is the difference between Eurobonds and foreign bonds?
Eurobonds are issued in a currency different from the country where they are issued, such as a U.S. company issuing bonds in Japan denominated in U.S. dollars. In contrast, foreign bonds are issued in a domestic market by a foreign entity but in the local currency, like a U.S. company issuing yen-denominated bonds in Japan, known as Samurai bonds. While Eurobonds target international investors, foreign bonds are designed for local markets.
What are bearer bonds?
Bonds for which the trustee did not keep records of who owned the bonds; only the clearing system knew who the bond owners were.
What are registered bonds?
Bonds for which ownership is recorded by either name or serial number.
What are global bonds?
Bond issued simultaneously in the Eurobond market and in at least one domestic bond market, ensuring sufficient demand and access to all fixed-income investors regardless of location.
For investors, bond interest income is usually taxed at the ordinary income tax rate.
