The most common bond cash flow structure is that of a standard fixed-coupon bond, often referred to as 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.
Amoritising 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.
Investors receive higher near-term cash flows on this amortising debt relative to bullet bonds and face lower credit risk because the borrower’s liability is reduced over time.
The fully amortising loan has a level semiannual payment equal to the sum of interest and principal repayment. We may calculate the periodic payment (A) as follows:
where
- A = Periodic payment amount
- r = Market interest rate per period
- Principal = Principal amount of loan or bond
- N = Number of payment periods
Two additional bond amortisation arrangements commonly encountered are sinking funds, used primarily by government and some corporate issuers, and waterfall structures, which are commonly used in asset-backed securities (ABS) and mortgage-backed securities (MBS).
Variable Interest Debt
Some bonds and most loans have variable interest payments, calculated using a market reference rate (MRR) and a credit spread. Financial intermediaries, such as banks, prefer floating-rate loan assets since they match their variable-rate liabilities, such as deposits. Loans or floating-rate notes (FRN) are also attractive to investors seeking to benefit from rising interest rates.
Recall that a variable-rate loan or FRN coupon consists of a periodically resetting MRR plus an issuer-specific credit spread.
FRN coupon = MRR + Credit spread.
Zero-Coupon Structures
Zero-coupon bonds repay principal at maturity but have no coupon payments. Zero-coupon bonds are often referred to as discount bonds, since they are priced below par if interest rates are positive. An investor’s sole source of return is the difference between the price paid and the principal, which represents a cumulative interest payment at maturity. Zero-coupon bonds are commonly issued by governments with tenors less than 12 months. As sovereign interest rates fell to (or below) zero in the wake of global financial crisis in 2008, zero-coupon bonds also became more common at longer maturities. Zero-coupon bonds are also created by financial intermediaries that sell individual interest or principal payments separated (or stripped) from sovereign bullet bonds.
Deferred Coupon Structure
Deferred coupon bonds pay no interest for the first few years and have a higher coupon paid later through maturity.
Issuers of deferred coupon bonds usually seek to conserve cash immediately following the bond issue, which may indicate lower credit quality or that the issuer is financing a construction project that does not generate income until completion.
