Learning Module 2
Fixed-Income Cash Flows and Types
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe common cash flow structures of fixed‑income instruments (amortizing, variable interest, zero‑coupon, deferred coupon) and contrast contingency provisions that benefit issuers (call) vs. investors (put, conversion).
Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed‑income securities, including domestic vs. foreign vs. Eurobonds, and tax treatment of original issue discount (OID) bonds.
1 · Acquisition of Intangible Assets
Bullet vs. Amortizing Bonds
Bullet bond: Full principal repaid at maturity. Periodic fixed coupon payments. Most common for government and corporate issuers.
Fully amortizing bond: Principal amortizes over life; equal periodic payments (interest + principal). Common for residential mortgages. Reinvestment risk increases (higher near‑term cash flows), but credit risk decreases (liability reduced over time).
Partially amortizing bond: Some principal amortized over life, with a balloon payment at maturity.
A = [r × Principal] / [1 − (1 + r)⁻ᴺ]
where A = periodic payment, r = periodic interest rate, N = number of periods
Sinking Funds & Waterfall Structures
Sinking fund: Issuer sets aside funds to retire principal early; reduces credit risk, increases reinvestment risk.
Waterfall structure: Principal repayment occurs sequentially — most senior tranche paid first, then next, etc. Payment shortfalls borne by junior tranches.
Variable Interest Debt
Floating‑rate notes (FRNs): Coupon = MRR + credit spread. Less interest rate risk than fixed‑rate bonds because coupons reset periodically.
Step‑up bonds: Coupon increases by specified margins at specified dates. Protects investors against rising rates; may incentivize issuers to call the bond.
Payment‑in‑kind (PIK): Interest paid by increasing principal outstanding (rather than cash). Used by highly levered firms; higher interest rate compensates for greater principal risk.
Credit‑linked notes: Coupon changes based on financial covenants or credit ratings.
Index‑Linked Bonds
Inflation‑linked bonds (linkers): Interest and/or principal linked to a price index (e.g., CPI).
Capital‑indexed bonds: Principal adjusted for inflation (e.g., TIPS). Coupon = fixed rate × inflation‑adjusted principal.
Interest‑indexed bonds: Only coupon is index‑linked; principal is fixed nominal.
Zero‑Coupon & Deferred Coupon Structures
Zero‑coupon bonds: No periodic interest; issued at discount; cumulative interest paid at maturity. No reinvestment risk.
Deferred coupon bonds: No interest for first few years, then higher coupon through maturity. Issuers use to conserve cash (e.g., construction projects).
2 · Contingency Provisions (Embedded Options)
Issuer has right to redeem (call) bond before maturity at fixed price.
Benefit to issuer: can refinance if interest rates fall.
Call protection period: No call allowed initially.
Call risk: Investors face reinvestment risk and limited price appreciation.
Make‑whole call: Issuer pays high price based on sovereign YTM; rarely exercised.
Investor has right to sell bond back to issuer at pre‑determined price (usually par).
Benefit to investor: protects against rising interest rates (price floor).
Yield is lower than comparable non‑putable bond (investor pays for the option).
If YTM < coupon, put feature is less valuable; bond behaves like option‑free bond.
Convertible Bonds
Conversion right: Investor can exchange bond for a fixed number of common shares at a pre‑determined conversion price.
Conversion ratio: Par value / Conversion price. Conversion value = Conversion ratio × Current share price.
Investors accept lower coupon (or even zero) in exchange for conversion rights.
If share price << conversion price, bond trades like a non‑convertible bond. If share price >> conversion price, bond trades like equity (tracks conversion value).
Contingent convertible (CoCo): Converts automatically on the downside (e.g., when bank capital ratio falls below minimum). Used by banks to absorb losses.
Conversion ratio = Par value / Conversion price
Conversion value = Conversion ratio × Current share price
Warrants: Attached (not embedded) option to buy equity; traded separately; used as yield enhancement.
3 · Legal, Regulatory & Tax Considerations
Bond Classification by Jurisdiction
ssued by an entity incorporated in the same country where the bond is issued and denominated in that country's currency.
Issued by an entity incorporated in another country, denominated in the host country's currency, and sold in that host country.
Issued outside the jurisdiction of any single country. Unsecured, can be in any currency. Subject to fewer listing, disclosure, and regulatory requirements.
Global bond: Issued simultaneously in the Eurobond market and in at least one domestic bond market.
Bearer vs. registered bonds: Eurobonds historically were bearer bonds; now most bonds are registered.
Currency of denomination has a stronger effect on price than where the bond is issued/traded.
Tax Considerations
nterest income: Usually taxed as ordinary income. Some bonds offer tax advantages (e.g., US municipal bonds exempt from federal tax).
Capital gains: Taxed differently from interest income; often lower rate for long‑term gains.
Original Issue Discount (OID): The difference between par value and issuance price.
OID tax provision (US): Prorated portion of OID recognized as taxable income each year; no capital gains tax at maturity.
No OID tax provision (e.g., Japan): No taxable income until maturity; then capital gains tax on the OID.
Some jurisdictions allow amortization of bond premiums as a tax deduction.
Feature | Domestic | Foreign | Eurobond |
|---|---|---|---|
Issuer location | Same as market | Different from market | Any (cross‑border) |
Currency | Local currency | Local currency | Any currency |
Regulatory oversight | High | High | Lower |
Typical investor base | Domestic | Domestic | International |
4 · Quick Reference — Contingency Provisions
Provision | Who Benefits | Effect on Yield | Key Feature |
|---|---|---|---|
Call | Issuer | ↑ Higher yield than non‑callable | Price cap at call price; call protection period |
Put | Investor | ↓ Lower yield than non‑putable | Price floor at put price |
Convertible | Investor | ↓ Much lower coupon | Tracks equity when share price >> conversion price |
CoCo | Issuer (systemic) | ↑ Higher yield | Automatic conversion on the downside |