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 priority.
- Issuer and investor rights can include call, put, conversion, sinking fund, collateral, and covenant provisions.
- Cash flow structures include bullet, amortizing, floating-rate, zero-coupon, step-up, deferred-coupon, and inflation-linked bonds.
- Seniority, security, covenants, and embedded options change credit risk, reinvestment risk, and interest rate risk.
- Level I questions often ask candidates to link a feature to the party it benefits and the yield compensation investors require.
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 repayment, or both. The contract defines the cash flow map and the legal claim if the issuer has trouble paying.
For CFA Level I, start every fixed-income item by reading the terms. The issuer may be a sovereign, municipality, agency, financial company, industrial company, or special purpose entity. The bond may be secured or unsecured. It may have fixed or floating coupons. It may mature in one payment or amortize over time.
Core bond features
Par value is the amount used to compute coupon payments and the principal due at maturity. A bond with USD 1,000 par and a 6 percent annual coupon pays USD 60 per year if coupons are annual, or USD 30 every six months if coupons are semiannual.
Maturity is the date principal is due. Coupon rate is the stated percentage applied to par. Coupon frequency tells how often interest is paid. Currency matters because payments in a foreign currency create exchange rate exposure for an investor whose base currency differs.
Seniority defines priority among creditors. Secured debt has a claim on pledged collateral. Unsecured debt relies on the issuer's general credit. Subordinated debt ranks below more senior debt and usually requires a higher yield.
Issuer and investor options
A callable bond gives the issuer the right to redeem the bond before maturity, usually at a call price. The issuer benefits when rates fall because it can refinance expensive debt. The investor is hurt because high coupon cash flows may disappear when reinvestment rates are lower.
A putable bond gives the investor the right to sell the bond back to the issuer at a stated price. The investor benefits when rates rise or credit quality worsens. The issuer must compensate investors less for a putable bond than for an otherwise similar option-free bond.
A convertible bond gives the investor the right to convert debt into common shares under specified terms. The investor accepts a lower coupon because the conversion feature has value. The issuer may use convertibles to reduce cash interest cost and appeal to investors who want upside.
Cash flow structures
| Structure | Cash flow pattern | Main exam point |
|---|---|---|
| Bullet | Coupons, then full principal at maturity | Principal risk is concentrated at maturity |
| Amortizing | Principal repaid over life | Lower final principal and different duration |
| Zero-coupon | No coupons, principal at maturity | Price is deep discount and return is price accretion |
| Structure | Cash flow pattern | Main exam point |
|---|---|---|
| Floating-rate | Coupon resets from reference rate plus margin | Lower interest rate duration than fixed-rate debt |
| Step-up | Coupon increases on schedule | Issuer often pays more if bond remains outstanding |
| Inflation-linked | Payments linked to inflation index | Real return protection depends on structure |
A bullet bond is the common fixed-coupon structure. It pays periodic coupons and returns all principal at maturity. An amortizing bond repays principal gradually. Mortgage loans and many asset-backed securities amortize, which means the principal balance changes over time.
A zero-coupon bond has no periodic interest. It sells below par and accretes toward par. The investor's return comes from the difference between purchase price and maturity value. Zero-coupon bonds have high interest rate sensitivity for a given maturity because cash flow is concentrated at the end.
A floating-rate note resets its coupon using a reference rate plus a quoted margin. If the reference rate rises, future coupon payments rise. This reset feature keeps the price closer to par on reset dates, so the note usually has less interest rate risk than a fixed-rate bond with the same maturity.
Covenants and funding choices
Covenants are contract terms that restrict issuer behavior or require issuer action. Negative covenants may limit additional debt, asset sales, liens, or restricted payments. Affirmative covenants may require financial statements, insurance, taxes, or minimum ratios.
Issuance can occur in public offerings or private placements. Public bonds tend to have broader distribution and more disclosure. Private placements can be tailored for large investors but usually have less liquidity. Liquidity affects the yield investors demand.
Structured aid: feature effect map
| Feature | Benefits issuer or investor | Likely yield effect |
|---|---|---|
| Call option | Issuer | Higher yield to investor |
| Put option | Investor | Lower yield to investor |
| Conversion option | Investor | Lower coupon or yield |
| Strong collateral | Investor | Lower yield versus unsecured debt |
| Subordination | Issuer or senior creditors | Higher yield to subordinated investor |
Exam focus
When a question gives a bond 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 usually increase required yield.
Also separate coupon rate from required return. The coupon defines promised cash flows. The market discount rate defines price. A high coupon does not by itself make a bond cheap, and a low coupon does not by itself make a bond expensive.
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 zero-coupon bond's return is primarily earned through: