Fixed-Income Cash Flows and Types

Fixed Income

Fixed-Income Cash Flow Structures

Learning Outcome Statement:

describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors

Summary:

This LOS covers various cash flow structures of fixed-income instruments, including amortizing debt, variable interest debt, zero-coupon structures, and deferred coupon structures. It explains how these structures impact the payments made over the life of the bond and how they benefit either the issuer or the investor.

Key Concepts:

Amortizing Debt

Amortizing debt involves periodic retirement of a portion of the principal along with interest payments over the life of the instrument, reducing credit risk due to the gradual decrease in the borrower's liability.

Variable Interest Debt

Variable interest debt adjusts the interest payments based on a market reference rate plus a credit spread. This structure can benefit investors during periods of rising interest rates but also carries credit risk.

Zero-Coupon Structures

Zero-coupon bonds do not make periodic interest payments but are issued at a discount and repay the principal at maturity. The investor's return is the difference between the purchase price and the principal.

Deferred Coupon Structures

Deferred coupon bonds delay interest payments until a specified future time, usually to conserve cash for the issuer. These bonds typically carry higher coupons post-deferral to compensate for the initial period without interest payments.

Formulas:

Periodic Payment for Amortizing Loan

A = \frac{r \times \text{Principal}}{1 - (1 + r)^{-N}}

This formula calculates the periodic payment for an amortizing loan, which includes both principal and interest components. The payment amount is fixed throughout the term of the loan.

Variables:

$A$ :: Periodic payment amount
$r$ :: Market interest rate per period
$Principal$ :: Principal amount of loan or bond
$N$ :: Number of payment periods

Units: currency units

Fixed-Income Contingency Provisions

Learning Outcome Statement:

describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors

Summary:

This LOS explores various cash flow structures of fixed-income instruments and contrasts the contingency provisions that can benefit either issuers or investors. Key types of bonds discussed include callable bonds, putable bonds, and convertible bonds. Each type has specific features that can influence the cash flows and risks associated with the bond.

Key Concepts:

Callable Bonds

Callable bonds allow the issuer the right to redeem the bond before its maturity at a predetermined price. This feature is beneficial to the issuer, especially if market interest rates fall, allowing them to refinance at lower rates. However, it introduces reinvestment risk for investors.

Putable Bonds

Putable bonds provide the bondholders the right to sell the bond back to the issuer at a predetermined price on specified dates. This feature is advantageous for investors, especially if interest rates rise, allowing them to reinvest at higher rates. It can force the issuer to refinance earlier than planned at potentially higher rates.

Convertible Bonds

Convertible bonds can be exchanged for a predetermined number of the issuer's common shares. This feature is attractive to investors if the issuer's share price appreciates significantly. Convertible bonds typically offer lower yields in exchange for the potential upside in conversion to equity.

Formulas:

Periodic Payment for Amortizing Bond

A = \frac{r \times \text{Principal}}{1 - (1 + r)^{-N}}

This formula calculates the periodic payment for an amortizing bond, which includes both interest and principal components.

Variables:

$A$ :: periodic payment
$r$ :: periodic interest rate
$Principal$ :: initial principal amount
$N$ :: number of periods

Units: currency

Conversion Ratio

\text{Conversion ratio} = \frac{\text{Convertible bond par value}}{\text{Conversion price}}

This ratio determines how many shares a bondholder gets per unit of bond par value when converting a bond into shares.

Variables:

$Convertible bond par value$ :: face value of the convertible bond
$Conversion price$ :: price at which the bond can be converted into equity

Units: dimensionless

Conversion Value

\text{Conversion value} = \text{Conversion ratio} \times \text{Current share price}

This value represents the worth of the bond if converted into shares at the current market price.

Variables:

$Conversion ratio$ :: number of shares received per unit of bond par value
$Current share price$ :: current market price of the issuer's shares

Units: currency

Legal, Regulatory, and Tax Considerations

Learning Outcome Statement:

describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities

Summary:

Fixed-income securities are influenced by various legal, regulatory, and tax considerations based on their issuance and trading jurisdictions. These factors determine the classification of bonds as domestic, foreign, or Eurobonds, each with distinct implications for issuers and investors. Legal and regulatory frameworks vary widely, affecting everything from bond issuance to investor accessibility. Tax considerations play a crucial role in the financial decisions of both issuers and investors, impacting the cost of debt and the taxation of interest and capital gains.

Key Concepts:

Domestic, Foreign, and Eurobonds

Bonds are classified based on the jurisdiction of their issuance. Domestic bonds are issued within the issuer's country, foreign bonds in a foreign country, and Eurobonds outside any single country's jurisdiction. This classification affects legal, regulatory, and tax treatments.

Legal and Regulatory Frameworks

The legal and regulatory environments vary by market and can influence the issuance and trading of bonds. For example, emerging markets might have different regulations compared to developed markets, affecting how bonds are issued and traded.

Tax Considerations

Tax implications are significant for both issuers and investors. Issuers consider the tax deductibility of interest expenses, while investors are concerned with the taxation of interest income and capital gains. Different bonds offer various tax advantages, such as municipal bonds in the U.S., which are often exempt from federal income tax.

Original Issue Discount (OID)

OID is the difference between the par value and the original issue price of a bond. Tax treatment of OID varies by country; for example, in the U.S., it is treated as interest income and taxed annually, whereas other jurisdictions may treat it differently.

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