HAMMER THIS INTO YOUR HEAD
- This module has multiple kinds of cashflow structures, but they all boil down to how the principal is repaid over time, and are usually exposed to two main risks: reinvestment risk (getting your money back early and having to find a new place to put it) and credit risk (getting your money back late and trusting the issuer to still be around). Every bond structure is just choosing where on this spectrum you sit.
- Bullet structure = principal repaid only at maturity → you receive fixed coupons (interest-only payments) each period and get the full par value back at the end → this front-loads interest risk onto the issuer (if rates crash the issuer re-invests the coupons for peanuts) and back-loads credit risk onto you, because your entire principal is exposed until the final day (if issuer runs away i.e default you get nothing).
- Amortizing = you pay interest + some principal each period, but there's still a lump sum (balloon) left at maturity; fully amortizing = same blended payments but sized so the balance hits exactly zero on the last payment - no balloon, no surprise, you're done.
- This reduces your credit exposure over time but means earlier payments are interest-heavy while later payments are principal-heavy, so the cash-flow profile is the mirror image of a bullet bond.
- Constant payment formula ties these pieces together: $\(PMT = PV \times \frac{r}{1 - (1 + r)^{-N}}\)$ where \(PV\) = loan principal, \(r\) = periodic interest rate, \(N\) = number of periods. Notice the numerator is just the first period's interest charge; the denominator fraction adjusts it upward so each flat payment also chips away at principal until the balance is exactly zero.
- Sinking fund literally means the fund is sinking or eroding. That is forced partial principal repayment over the bond's life. The best example is suppose you are 70 years old with million dollars in savings. You want to spend this money before you die so you would make your savings sink. This means less principal outstanding at maturity → lower credit risk for you → you get your money back early and might redeploy at lower interest rate thereby increasing re-investment risk.
- Waterfall = priority queue for principal in ABSs and MBSs → pool sliced into tranches by seniority → senior gets all principal first → junior gets zero principal until senior is fully repaid → but both get interest throughout.
- Junior tranche absorbs losses first and receives principal last → this concentrates credit risk in the junior slice → which lets the senior tranche price like near-risk-free debt → investors in junior demand higher yield to compensate → that yield spread is the entire reason structured products exist.
- Floating-Rate Note (FRN) = your coupon floats with the market - think of it as a salary that adjusts for inflation: you get the Market Reference Rate (MRR - the going rate in the market) + a fixed credit spread (your premium for lending to this borrower, measured in basis points where 100 bps = 1%) → this kills reinvestment risk because your coupon resets each period, but it means you never lock in a high rate when rates are rising - you're always one reset behind.
- Step-up coupon = coupon rises on a preset schedule → compensates you for holding longer-dated risk → think of it as a loyalty raise - the issuer pays you more the longer you stay.
- Leveraged loan / credit-linked note = coupon rises when the issuer's credit deteriorates → e.g. debt/EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) crosses 3× and your spread jumps from MRR + 2.5% to MRR + 3% → it's an automatic insurance adjustment - the riskier the borrower gets, the more they pay you.
- Payment-in-Kind (PIK) = issuer pays your interest with more bonds, not cash → think of a friend who owes you money and "pays" you by writing a bigger IOU → the firm does this because it can't generate enough cash to service debt → you get higher yields but your entire return depends on the issuer eventually being good for it - if they default, all those extra bonds are worthless too.
- Green bonds = coupon penalizes the issuer for missing environmental targets → e.g. miss your CO₂ reduction goal and your coupon steps up → it's a put-your-money-where-your-mouth-is mechanism that aligns bondholder returns with sustainability outcomes.
- Inflation-linked bonds come in two flavors: interest-indexed (coupon adjusts for inflation but principal stays fixed - you're protected on income but your $1,000 par erodes in real terms) vs capital-indexed like Treasury Inflation-Protected Securities (TIPS) (coupon rate stays fixed but principal adjusts - so if inflation is 3%, your $1,000 becomes $1,030 and the fixed coupon applies to the bigger base, protecting both income and principal).
- Callable Bond: Think of your mortgage - when rates drop, you refinance and the bank loses a high-interest borrower. A callable bond is the same thing from the issuer's side. Rates fall from 6% to 4%, issuer calls your bond at $1,020, reissues at 4%, saves $19.20/year → you lose a 6% coupon and reinvest at 4%. This is call risk - your upside is capped at the call price (bond can't trade much above $1,020 even if rates collapse) but your downside is uncapped. Call protection period = the years before they can do this to you → you demand higher yield to accept this asymmetry.
- Putable Bond: Think of a job with a guaranteed severance - if things go bad, you can walk away and still get paid. A putable bond gives you the right to sell it back to the issuer at par. Rates spike from 4% to 7%, your bond's market value drops to $850, but you put it back at $1,000 and redeploy at 7% → you're protected on the downside. Real-world: in 2008, many corporate bonds crashed 20-30% in value - if you held a putable bond, you could force the issuer to buy it back at par while everyone else was stuck selling at \(700-\)800. You pay for this protection through a lower yield.
- Convertible = your right to swap the bond for the issuer's stock → you get bond safety (fixed coupons, principal protection) plus equity upside → issuer pays a lower coupon because you accepted stock optionality instead. Three numbers to know: conversion price (\(40/share), conversion ratio (\)1,000 ÷ $40 = 25 shares), conversion value (25 × current share price).
- Who holds the option determines who adjusts the price: callable bond sells cheaper than a straight bond (issuer has the option, you demand more yield) → putable bond sells richer (you have the option, you accept less yield) → convertible sells richer still (you have equity upside, issuer pays less coupon). The price gap between the option-embedded bond and the straight bond always equals the option's value.
- CoCo = emergency parachute for banks → bank starts losing money and equity drops below the regulatory minimum, your bond automatically becomes stock → debt shrinks, equity fattens, regulators happy. You went to sleep holding a bond and woke up holding stock in a struggling bank - worst possible moment to become a shareholder.
- Where a bond is issued, traded, and what currency it's in = three separate things that determine which laws apply and what yield you get.
- Domestic = issued and traded in issuer's home country
- Foreign = issuer sells in another country's market (UK firm issuing USD bonds in the US)
- Eurobond = issued outside any single country's jurisdiction, any currency (Chinese firm issuing yen bonds outside Japan) → less regulation, which is the whole point
- Global bond = trades both domestically and in the Eurobond market
- Currency matters most — a USD bond's yield is driven by US rates regardless of who issued it or where
- Bearer bond = whoever holds the paper owns it (old style); Registered = ownership recorded (modern standard)
- Sukuk = Islamic-compliant bond where payments are structured as rent on assets, not interest, to satisfy Sharia law