Title LM02 Fixed-Income Cash Flows and Types IFT Notes.pdf ✅

LM02 Fixed-Income Cash Flows and Types 2025 Level I Notes © IFT. All rights reserved 1 LM02 Fixed-Income Cash Flows and Types 1. Introduction ........................................................................................................................................................... 2 2. Fixed-Income Cash Flow Structures ............................................................................................................. 2 3. Fixed-Income Contingency Provisions ........................................................................................................ 6 4. Legal, Regulatory, and Tax Considerations ............................................................................................... 9 Summary ...................................................................................................................................................................12 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM02 Fixed-Income Cash Flows and Types 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  Common fixed income instrument cash flow structures and their implications for issuers and investors  Legal, regulatory, and tax considerations faced by fixed income issuers and investors 2. Fixed-Income Cash Flow Structures Not all bonds are structured to make periodic interest payments and one lump-sum principal payment at the end. In this section we will look at the different ways in which principal and interest can be paid over the bond’s life. Principal Repayment Structures Bullet bond: The principal is paid all at once at maturity. Such a type of bond is called a bullet bond. Bullet Bond: Payment Structure for a 5-year, $1000 Bond with 6% Coupon Paid Annually Year Cash flow in $ Interest Payment (in $) Principal Repayment (in $) Outstanding principal (in $) 0 -1,000 1,000 1 60 60 0 1,000 2 60 60 0 1,000 3 60 60 0 1,000 4 60 60 0 1,000 5 1000 + 60 = 1060 60 1,000 0 Key points to be noted for a bullet bond (based on the table above):  No part of the principal is paid before maturity. The $1,000 amount towards principal is paid all at once at maturity.  During the life of the bond, the principal remains outstanding.  The last payment includes both the coupon payment of $60 and principal payment of $1,000. Fully amortized: A fully amortized bond is one in which the principal is paid little by little in equal payments over the bond’s life, so that it is repaid in full by the maturity date. The periodic payments made by the issuer consist of interest and a part of principal as shown for a sample bond in the table below. Fully Amortized Bond: Payment Structure for a 5-year, $1,000 Bond with 6% Coupon Paid Annually, market interest rate = 6%
LM02 Fixed-Income Cash Flows and Types 2025 Level I Notes © IFT. All rights reserved 3 Year Investor cash flows in $ a = b + c Interest Payment (in $) b Principal Repayment (in $) c Outstanding principal (in $) Pt-1-c 0 -1,000 1,000 1 237.40 60 177.4 822.6 2 237.40 49.36 188.04 634.56 3 237.40 38.07 199.32 435.24 4 237.40 26.11 211.28 223.96 5 237.40 13.44 223.96 0 Partially amortized: A partially amortized bond is one in which only a part of the principal is repaid over the bond’s life. The remaining big part of the principal is paid at maturity making it a balloon payment. This is a hybrid between the bullet and the fully-amortized bond. The table below shows a sample bond. Partially Amortized Bond: Payment Structure for a 5-year, $1,000 Bond with 6% Coupon Paid Annually Year Investor cash flows (Coupon) in $ Interest Payment (in $) Principal Repayment (in $) Outstanding principal (in $) 0 -1,000 1,000 1 201.92 60 141.92 858.08 2 201.92 51.48 150.43 707.65 3 201.92 42.46 159.46 548.19 4 201.92 32.89 169.03 379.17 5 401.92 22.75 379.17 0 Sinking Fund Arrangements This allows for full or partial amortization of a bond prior to its maturity. It specifies the portion of the bond’s principal outstanding that must be repaid each year throughout the bond’s life. Three sinking fund arrangements:  Standard: Issuer sends the repayment principal amount to the trustee. The trustee then either redeems bonds to this value or decides which bonds to retire through a lottery.  Accelerated: Issuer retires more than the specified portion of the bond’s notional principal. The amount redeemed steadily increases each year. If there is any remaining principal, it is redeemed at maturity.  Call provision: Bonds with call provision give the issuer the right to call (repurchase)
LM02 Fixed-Income Cash Flows and Types 2025 Level I Notes © IFT. All rights reserved 4 the bond before maturity. Callable bonds usually have higher yields as investors bear the risk that they may be called. It is beneficial to the issuer and disadvantageous to the bondholder. The bonds to be retired are selected randomly. A sinking fund arrangement results in  Lower credit risk: The objective of a sinking fund provision is to reduce credit risk for investors because the issuer does not have to pay a large payment at maturity. From an investor’s perspective, there is less credit risk as the principal is being paid over the bond’s term.  Higher reinvestment risk: Receiving principal payments before maturity also means the investor has to bear reinvestment risk, i.e., if the money received cannot be invested at the same or higher expected return. In a declining interest rate environment, there is a risk of investing the proceeds at a lower rate. Waterfall structures This structure is commonly used in asset-backed securities (ABS) and mortgage-backed securities (MBS). Tranches with different priority of claims to the cash flows are created as shown in Exhibit 5 from the curriculum. Interest payments are paid to all classed with no preference. However, the repayment of principal occurs sequentially – with the most senior tranche receiving principal payments first, followed by the second-highest tranche and so on. Shortfalls in principal payment due to defaults are borne by the most junior tranches (since senior tranches are paid first). In the above diagram, Tranche A faces the lowest credit risk, while Tranche C faces the highest credit risk. Coupon Payment Structures Fixed periodic coupons  This is the most basic form of coupon payment. A fixed interest is paid either semi- annually or annually. Floating-rate notes (FRN) (a.k.a. Variable interest debt)  A bond whose coupon is set based on some reference rate plus a spread.