Coupon Structures Explained | CFA Level I Fixed Income

In this lesson, we will explore various coupon structures, starting with the plain vanilla bond and moving on to more complex structures.

1. Bullet Coupon Structure

The plain vanilla bond is characterized by a bullet coupon structure, which includes:

• Fixed coupon payouts
• A final payment (balloon payment) comprising the principal and final coupon payment

Not all bonds have this structure; some repay principal throughout the course of the bond, such as:

• Fully amortising bonds: principal payments are repaid throughout the bond’s life
• Partially amortising bonds: principal payments are made over time, with a final balloon payment at maturity

2. Sinking Fund Provisions

To make long-dated bonds more attractive, issuers can include sinking fund provisions, which require the borrower to retire a certain amount of bonds each year. This can be done through redeeming bonds at par value or buying back bonds from the open market.

3. Floating-Rate Notes (Floaters)

Floating-rate notes pay variable interest based on a current market rate of interest, also known as the reference rate. These bonds can have caps and floors to limit the maximum and minimum coupon rates, respectively.

4. Inverse Floaters and Index-Linked Bonds

Inverse floaters have a negative correlation with the reference rate, while index-linked bonds have their coupon rate based on indices such as commodity, equity, or inflation indices. Inflation-linked bonds, or linkers, are the most common type of index-linked bonds.

5. Credit-Linked Coupon Bonds

Coupon rates for these bonds are inversely correlated with the issuer’s credit rating, offering some protection against credit downgrades. However, higher coupon payments might worsen the issuer’s financial situation and increase the probability of default.

6. Step-Up Coupon Bonds

Step-up coupon bonds have a coupon rate that increases over time according to a predetermined schedule. These bonds typically have a call feature that allows the issuer to redeem the bond issue at a set price at each step-up date.

7. Deferred Coupon Bonds (Split Coupon Bonds)

Deferred coupon bonds only start making regular coupon payments after a certain period of time. They are issued by firms anticipating insufficient cash flows to make coupon interest payments.

8. Zero-Coupon Bonds

Zero-coupon bonds pay no interest prior to maturity and are sold at a discount to their par value. The interest is paid at maturity when bondholders receive the par value.

9. Payment-in-Kind Bonds

Payment-in-kind bonds pay coupons in kind by increasing the principal amount of the outstanding bonds. These bonds typically have higher yields due to their lower perceived credit quality and to compensate investors for the higher credit risk.