Cash Flow Types in Fixed Income Securities

The first thing that any investor related to fixed income markets first notices about the market is the sheer variety of the instruments being traded. A large variety also means that the trading in bonds becomes more complex. Investors need to understand the different types of fixed-income securities that are available in the market.

Fixed income securities can be classified based on various parameters. In this article, we will have a look at the different types of bonds from a cash flow point of view.

1. Plain Vanilla: Plain vanilla bonds, also known as bullet payment bonds have the most common type of cash flow in the market. They are called bullet payment bonds since the periodic payments known as coupon payments are equal, whereas, in the end, the principal is paid in one shot, as a lumpsum payment. Since this type of cash flow is used most often, they are called plain vanilla bonds.

2. Amortized Bonds: Amortized bonds have a totally different cash flow pattern as compared to plain vanilla bonds. These bonds follow the amortization process. This means that every payment which is made to the bondholder consists of both principals as well as interest.

   The composition of principal and interest changes during the repayment period. The initial payments have a larger interest component whereas the later periods have a larger interest component. Such bonds mimic the cash flow pattern of an annuity. Hence, they are often referred to as annuity bonds. Amortized bonds can either be fully amortized or can be partially amortized.

   Partially amortized are hybrid bonds which combine the cash flow patterns of both types of bonds mentioned above. This means that a part of their value is returned in the form of amortized payments whereas another part is returned in the form of periodic coupon payments as well as bullet payments at the end of the tenure.

3. Perpetual Bonds: Perpetual bonds, also known as “perps” or “consols” form another type of cash flow in the fixed income security market. The defining feature of perpetual bonds is that these bonds never return the principal which has been taken. Instead, these bonds keep on making periodic interest payments forever.

   The nominal value of coupon payments remains the same throughout the years. However, because of the time value of money, the real value of coupon payments keeps eroding through the years until finally, it accounts for a negligible value in the distant future.

   There are very few perpetual bonds in the global market. This is because there are very few such entities that investors trust are capable of making coupon payments forever. If investors do not think that the entity will exist in the distant future, then they will lend money to such an entity for an extremely long term duration.

4. Balloon Payments: Balloon payments are similar to bullet payments in the sense that there are periodic payments and lumpsum payments. However, instead, of repaying the entire principal debt at one go, companies break it into several balloon payments.

   For instance, if a company has borrowed $100 for 10 years, it may pay interest on the entire amount for the first five years and then may repay 50% of the principal i.e., $50 in the fifth year. Then, the company will continue paying investors interest on the balance amount until the entire amount is paid off in the tenth year.

   Companies use a ballooning cash flow structure when they believe that the future payments that they receive will be considerably larger than their current cash flow. Hence, they would want to retire some of the excess debt in order to save interest payments.

5. Sinking Fund: Sinking fund-based bonds provide another variant of cash flow to investors. A sinking fund is typically a fund in which the borrowers keep adding money on an annual basis. The money in this fund is then used to retire a pre-specified number of bonds. For instance, if a company has $100 worth of bonds outstanding and it has a sinking fund arrangement, it may be contractually required to reduce the principal value of outstanding bonds to $90 in the first year, $80 in the next year, and so on.

   Bonds are identified based on a random program and those bondholders are required to surrender their bonds in lieu of full cash payment. It is also possible that instead of fully paying out some bondholders, the company may decide to reduce the outstanding principal by 10% across bondholders.

   The sinking fund arrangement has some drawbacks for both sides. For instance, the company may not be able to buy out its bonds if the market rates of such bonds are high. Also, the investors who receive the funds earlier than expected are exposed to reinvestment risk since they may not be able to deploy their funds to earn the same rate of return. However, many companies and investors still prefer this approach since it prevents companies from overleveraging and creating unnecessary credit risks.

The fact of the matter is that there are a wide variety of cash flow structures available to investors. Based on their individual time preference, the current interest rates as well as expectations of future interest rates, investors can decide on the type of structure that is most convenient to them.