8.1 Bond Features, Issuance, and Cash Flow Structures
Key Takeaways
- A bond is a contractual debt claim defined by issuer, maturity, par value, coupon rate, coupon frequency, currency, and seniority of claim.
- Embedded options (call, put, conversion) and provisions (sinking fund, collateral, covenants) shift value between issuer and investor.
- Cash flow structures include bullet, fully and partially amortizing, floating-rate, zero-coupon, step-up, deferred-coupon, and inflation-linked bonds.
- Issuer-owned options raise required yield; investor-owned options lower it; the rule appears on most feature questions.
- Fixed Income carries an 11-14% Level I weight (about 20-25 of the 180 questions), so feature recognition is high-value.
Start with the bond contract
A bond is a debt instrument that promises one or more future cash flows. The investor lends money today; the issuer promises interest, principal, or both, on a fixed schedule. The legal document (the indenture) defines the cash flow map and the creditor's claim if the issuer cannot pay. On the CFA Level I exam, Fixed Income is Topic 7, weighted 11-14% (roughly 20-25 of the 180 questions), so reading bond terms quickly is a high-yield skill.
Start every fixed-income item by reading the terms. The issuer may be a sovereign, non-sovereign government, quasi-government agency, supranational (such as the World Bank), financial corporation, non-financial corporation, or special purpose entity. The bond may be secured or unsecured, fixed- or floating-rate, and may repay in one payment or amortize over time.
Core bond features
Par value (face value, principal, maturity value) is the amount used to compute coupons and the principal due at maturity. A USD 1,000 par bond with a 6% annual coupon rate pays USD 60 per year if coupons are annual, or USD 30 every six months if semiannual. Maturity (tenor) is when principal is due. Coupon frequency sets how often interest is paid; US corporate and Treasury bonds typically pay semiannually, while many European bonds pay annually.
Currency matters because a bond denominated in a currency other than the investor's base currency carries exchange-rate exposure; a dual-currency bond pays coupons in one currency and principal in another.
Seniority ranks creditors. Secured debt has a claim on pledged collateral; unsecured debt (a debenture in the US) relies on general credit; subordinated debt ranks below senior debt and demands a higher yield.
Issuer and investor options
A callable bond lets the issuer redeem the bond early, usually at a declining call schedule. The issuer benefits when rates fall and it can refinance; the investor faces reinvestment risk, so a callable bond requires a higher yield than an option-free bond. A putable bond lets the investor sell the bond back at a set price, valuable when rates rise or credit deteriorates, so it requires a lower yield. A convertible bond lets the investor exchange the bond for common shares; the conversion feature has value, so the investor accepts a lower coupon.
Cash flow structures
| Structure | Cash flow pattern | Main exam point |
|---|---|---|
| Bullet | Coupons, then full principal at maturity | Principal risk concentrated at maturity |
| Fully amortizing | Level payments; principal repaid over life | No balloon; lower duration than a bullet |
| Partially amortizing | Amortizes plus a balloon payment | Residual principal risk at maturity |
| Zero-coupon | No coupons; par at maturity | Return is price accretion; highest duration |
| Floating-rate note | Coupon = reference rate + quoted margin | Low interest-rate duration; resets to par |
| Step-up | Coupon rises on a schedule | Often tied to a credit-linked call incentive |
| Inflation-linked | Principal/coupon indexed to inflation | Protects real return |
A bullet bond is the conventional fixed-coupon structure. A fully amortizing loan (most mortgages, many asset-backed securities) repays principal gradually, so its outstanding balance and duration fall over time. A zero-coupon bond sells at a deep discount and accretes toward par; with all cash flow at the end, it has the highest interest-rate sensitivity for a given maturity.
A floating-rate note (FRN) resets its coupon at each reset date using a reference rate (now commonly SOFR after the LIBOR transition) plus a margin; because the coupon tracks the market, its price stays near par on reset dates and its rate duration is low.
Covenants and funding choices
Covenants are contract terms that restrict the issuer or require action. Negative (restrictive) covenants limit additional debt, liens, asset sales, or restricted payments. Affirmative covenants require timely financial statements, insurance, tax payment, or minimum ratios. Stronger covenants reduce credit risk and lower required yield.
Issuance occurs through public offerings (broad distribution, more disclosure) or private placements (tailored for large investors, less liquid). Lower liquidity raises the yield investors demand.
Structured aid: feature effect map
| Feature | Benefits | Likely yield effect |
|---|---|---|
| Call option | Issuer | Higher yield to investor |
| Put option | Investor | Lower yield to investor |
| Conversion option | Investor | Lower coupon/yield |
| Strong collateral | Investor | Lower yield vs. unsecured |
| Subordination | Senior creditors | Higher yield to subordinated investor |
| Sinking fund | Both | Reduces credit risk; adds some call-like risk |
Exam focus
When a question gives a feature, ask who owns the right. Issuer-owned options hurt the investor and require compensation; investor-owned options help the investor and reduce required yield. Stronger collateral and covenants reduce credit risk. Subordination, weak covenants, long maturity, and illiquidity raise required yield.
Separate coupon rate from required return. The coupon defines promised cash flows; the market discount rate defines price. A high coupon does not make a bond cheap, and a low coupon does not make it expensive. A common trap pairs a high coupon with hidden call risk or weak credit.
A callable bond most likely benefits the issuer because the issuer can:
Compared with otherwise similar senior unsecured debt, subordinated debt most likely offers investors:
A floating-rate note tends to have a lower interest-rate duration than a fixed-rate bond of the same maturity primarily because its: