Introduction
Bonds are often described simply as fixed-income securities, but not all bonds generate income in the same way. The structure of a bond determines how its cash flows respond to interest rates, inflation and market conditions.
What Is a Bond?
A bond is a debt security through which an investor lends money to an issuer such as a government, corporation or supranational institution. In return, the issuer promises cash flows according to the bond’s terms and normally repays the face value, or par value, at maturity.
A traditional coupon bond has two main cash-flow components: periodic interest payments and repayment of principal. If a $1,000 bond has a 5% annual coupon, its annual coupon payment is $50.
1. Fixed-Rate Bonds
A fixed-rate bond pays a predetermined coupon rate throughout its life. The coupon is fixed, but the market price is not. When market yields rise, an existing fixed coupon becomes less attractive and the bond’s price generally falls. When yields fall, the opposite normally occurs.
Annual Coupon = Face Value × Coupon Rate
Fixed-rate bonds offer predictable nominal cash flows, but they expose investors to interest-rate risk and inflation risk. Longer-maturity bonds are usually more sensitive to changes in yields.
2. Floating-Rate Bonds
A floating-rate note (FRN) pays a coupon that resets periodically using a reference rate plus a contractual spread. A simple representation is: Coupon Rate = Reference Rate + Spread.
Coupon Rate = Reference Rate + Spread
If a reference rate is 3.0% and the spread is 1.5%, the coupon is 4.5%. If the reference rate later rises to 4.0%, the coupon resets to 5.5%, subject to the bond’s exact terms. This reset mechanism usually makes floating-rate bonds less sensitive to changes in risk-free rates than comparable fixed-rate bonds, although credit and liquidity risks remain.
Coupon Rate = Reference Rate + Spread
3. Zero-Coupon Bonds
A zero-coupon bond makes no periodic coupon payments. It is typically bought below face value and repays face value at maturity. If an investor pays $750 today for a bond that repays $1,000 in five years, the return comes entirely from the price accretion.
The annualized return r satisfies 750(1+r)^5 = 1,000, giving approximately 5.92%. Because the entire cash flow is concentrated at maturity, long-dated zero-coupon bonds can be highly sensitive to interest-rate changes.
4. Inflation-Linked Bonds
Inflation-linked bonds are designed to protect purchasing power by linking principal or cash flows to an inflation index. U.S. Treasury Inflation-Protected Securities (TIPS), for example, adjust principal with changes in the Consumer Price Index.
If adjusted principal rises from $1,000 to $1,030 and the coupon rate is 2%, the annual coupon calculated on that principal becomes $20.60. Inflation-linked bonds remain exposed to changes in real yields, duration and market liquidity.
Comparing the Four Bond Types
Fixed-rate, floating-rate, zero-coupon and inflation-linked bonds solve different cash-flow and risk-management problems. The bond structure should therefore be evaluated together with issuer credit quality, maturity, yield, duration, currency, liquidity and any embedded options.
Key Takeaways
Fixed-rate bonds provide predictable nominal coupons but can be sensitive to interest rates. Floating-rate coupons reset with a reference rate and normally reduce rate sensitivity. Zero-coupon bonds concentrate the cash flow at maturity. Inflation-linked bonds are designed to protect against inflation, but their market prices can still fall when real yields rise.