Floating, step-up, inflation-linked and zero-coupon bonds

What other ways can a bond pay interest?

A plain bond pays the same fixed coupon until maturity. Everything in this lesson changes one thing: when the cash arrives, or what moves it. The coupon type decides which risk the investor keeps.

Coupon structuresbeyond the plain fixed coupon

• Variable interest Memorize the coupon moves
  • Floating-rate note Memorize MRR (resets) + credit spread (fixed)
  • Step-up bond Memorize coupon rises by set amounts on set dates
  • Event-driven coupon Use it spread steps up if leverage, rating or a target worsens
  • Payment-in-kind Memorize interest paid by adding to principal
• Index-linked Memorize cash flows follow a price index
  • Capital-indexed Memorize principal moves; coupon = real rate × adjusted principal
  • Interest-indexed Memorize principal fixed; coupon carries the inflation
• Little or no cash coupon Memorize priced below par
  • Zero-coupon bond Memorize one payment at maturity; no reinvestment risk
  • Deferred coupon bond Memorize nothing for a few years, a higher coupon later

How does variable interest work?

Floating-rate notes (FRNs) and most loans pay a coupon of a market reference rate (MRR) plus a credit spread. The MRR resets each period and the spread is fixed at issue. Banks like floating-rate assets because their own funding, such as deposits, floats too.

Because the coupon follows rates, an FRN has little interest rate risk. It still has credit risk: if the issuer looks weaker, investors want a higher yield and the price falls, whatever the MRR does.

Step-up bonds and event-driven coupons

Step-up bonds raise the coupon by set amounts on set dates. They protect investors against rising rates and, because the cost climbs, can encourage the issuer to call the bond (the next lesson covers calls).

Other coupons change with an event. A leveraged loan is a loan to a lower-quality borrower, and its spread often depends on a leverage ratio, so a weaker balance sheet pays more. This lets the borrower obtain debt at a lower starting spread. Credit-linked notes tie the coupon to a covenant or a credit rating. Sustainability-linked bonds step the coupon up if an environmental target is missed. Green bonds are different: they carry an ordinary coupon but fund projects with an environmental benefit.

Event-driven couponsthe trigger decides the name

• Leveraged loan Use it spread set by a leverage ratio grid; lower-quality borrowers
• Credit-linked note Use it coupon tied to a covenant or a credit rating
• Sustainability-linked bond Know the idea step-up if an environmental target is missed

Payment-in-kind

A payment-in-kind (PIK) feature lets the issuer pay interest by increasing the principal outstanding instead of paying cash. Highly levered issuers use it to conserve cash, and investors demand a higher rate because their claim grows and so does the risk.

$$P_t = P_0 (1 + c)^{t}$$

How do inflation-linked bonds work?

Index-linked bonds tie interest and/or principal to an index. In practice almost all use a broad consumer price index, so they are inflation-linked bonds (linkers). A fixed bond pays nominal cash flows whose buying power erodes with inflation. A linker keeps the cash flows in real terms. Most are issued by governments.

There are two designs.

• A capital-indexed bond scales the principal by the index, and the coupon is the fixed real rate times the adjusted principal. Treasury Inflation-Protected Securities (TIPS) in the United States work this way. Deflation can shrink the principal, but investors usually receive at least par at maturity.
• An interest-indexed bond keeps the principal fixed and puts the inflation adjustment in the coupon, like an FRN whose reference rate is inflation. It is issued more often by private financial intermediaries than by governments.

$$C = \frac{c_{real} \times \text{Par} \times I_1 / I_0}{m}$$

Here I₁ ÷ I₀ is the change in the index since the start and m is the payments per year.

What are zero-coupon and deferred coupon bonds?

Zero-coupon bonds pay no coupons. They are sold below par (while rates are positive) and repaid at par, so the whole return is the climb to par. Governments issue them for terms under a year, and dealers also strip the coupons and principal off government bonds to make them. With no coupons to reinvest, a zero has no reinvestment risk, which makes it useful for funding a known future payment. It still carries interest rate and credit risk.

Deferred coupon bonds pay nothing for the first few years and a higher coupon later. Issuers use them to conserve cash while a project is built or while a weak credit recovers. They are usually priced below par.

Exam tip The coupon type decides the risk you keep: rates (fixed), inflation (nominal), credit (all of them), reinvestment (anything that pays coupons, so not zeros).

Go deeper Real versus nominal return on a linker

A linker’s coupon rate is a real rate: it already excludes the inflation compensation, which arrives through the principal. To compare with a nominal bond, add expected inflation to the real yield (the Fisher relation from the rates and returns lesson). The gap between a nominal bond’s yield and a linker’s real yield is the market’s inflation expectation plus a risk premium.

Go deeper Why zero-coupon issuance spread to longer maturities

Zeros used to be mostly short-term government bills. When government yields fell to around zero, or below, after the 2008 crisis, a coupon at market rates would have been close to nothing anyway, so issuing at longer maturities without a coupon cost issuers little and suited investors who wanted a single known payment. A zero priced at a negative yield sells above par, which is why the discount label only holds while rates are positive.

Go deeper Sukuk and rental payments

Some Islamic-finance securities replace interest with a share of rental or profit from assets. They are a legal form rather than a coupon type, and the last lesson of this module covers them.