A 10-year corporate bond and a 30-year mortgage-backed security both pay interest, but their cash flow shapes, contingency provisions, and tax treatment differ in ways the exam tests relentlessly.
The sections below describe how a bond returns principal and contrast the contingency provisions, sorting which ones benefit issuers and which benefit investors.
Bullet (plain vanilla) bonds pay periodic coupons and return full principal at maturity. Fully amortizing bonds pay equal periodic payments that blend interest and principal, reaching zero balance at maturity (residential mortgages). Partially amortizing bonds amortize some principal and pay a balloon (remaining principal) at maturity.
Sinking fund provisions force the issuer to retire principal on a schedule, by open-market repurchase or by calling at par. Lower credit risk for remaining holders, reinvestment risk for those called.
Floating-rate notes (FRNs) reset the coupon periodically: reference rate + quoted margin. Step-up coupons rise on schedule. Deferred-coupon bonds skip early payments. Zero-coupon bonds pay no coupons; return is price-to-par accretion. Index-linked bonds tie principal or coupon to an index (CPI for inflation-linked).
Common mistakes
- Confusing callable and putable. Callable benefits the issuer (redeems when rates fall). Putable benefits the investor (sells back when rates rise). Trap: "the investor calls when rates fall."
- Calling all foreign-currency bonds Eurobonds. Foreign bond = local currency of a foreign market (Yankee, Samurai). Eurobond = issued outside any single country's jurisdiction. Trap: classifying a JPY bond sold in Tokyo by a US issuer as a Eurobond. That is a Samurai.
- Treating all amortizing bonds as fully amortizing. Partially amortizing bonds leave a balloon at maturity. Trap: assuming a partially amortizing 30-year bond has zero balance at year 30.
Bottom line
- Bullet pays all principal at maturity. Fully amortizing spreads principal. Partially amortizing leaves a balloon. Sinking fund retires principal on a schedule.
- Issuer-benefit options: callable, prepayment, caps on floaters. Investor-benefit options: putable, convertible, floors on floaters.
- Embedded issuer options raise required yield; embedded investor options lower it.
- Eurobonds are issued outside any single jurisdiction, often bearer form, lighter regulation. Foreign bonds use the local currency of a foreign country (Yankee, Samurai).
Exam shortcut
For who benefits from an embedded option: the party who chooses to exercise. Issuer exercises calls and prepayments. Investor exercises puts and conversions. For Eurobond vs. foreign bond: Eurobond escapes any single country's regulation; foreign bond uses the country's local currency (Yankee USD, Samurai JPY, Bulldog GBP). For covenants: "must" = affirmative, "cannot" = negative.
The full lesson (about 1,645 words, 11 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- cash flows and types
Browse all free CFA Level I lessons or jump into free CFA Level I practice questions.