Set out coupon designs that do not pay a fixed rate
The idea
A floating-rate note pays a reference rate plus a quoted margin, resetting periodically, so its price stays near par and its interest rate risk is confined to the short period until the next reset. A step-up coupon rises on a schedule, whereas a credit-linked coupon rises when the issuer is downgraded, which protects holders as credit deteriorates. A payment-in-kind bond pays interest in more bonds rather than cash, conserving the issuer's cash and signalling weakness. An index-linked bond adjusts principal or coupon with an inflation measure, transferring inflation risk from holder to issuer.
A practice question
Why does a floating-rate note's price stay close to par?
- Because its coupon resets periodically to the prevailing reference rate — correct
- Because it has no credit riskWhy not: It carries the issuer's credit risk like any other bond, and a downgrade will move its price — the quoted margin is fixed even though the reference rate is not.
- Because its principal is guaranteedWhy not: No more guaranteed than any other unsecured claim on the same issuer.
When the coupon moves with the market, there is little for the price to adjust. Only the credit spread and the period until the next reset create price variation.
A harder one
What does a payment-in-kind coupon indicate about an issuer?
- That it is highly ratedWhy not: The opposite. Paying interest in more debt is a structure for borrowers who cannot spare the cash, and it commands a high yield.
- That it prefers to conserve cash — correct
- That its coupon is tax exemptWhy not: Tax exemption is a feature of certain municipal issues and is unrelated to how the coupon is settled.
That preference usually signals financial pressure. Paying interest in more debt rather than cash preserves liquidity and compounds the obligation, and investors demand a high yield for the combination.
The hardest tier
Why is a step-up coupon linked to a ratings downgrade valuable to holders?
- Because the issuer's rating is guaranteed not to fallWhy not: Nothing in the structure prevents a downgrade. It changes what the holder receives if one happens.
- Because it converts the bond to equity on downgradeWhy not: That is a conversion feature, and converting into the equity of a deteriorating issuer would be no protection at all.
- Because compensation rises precisely when the credit risk being borne has increased — correct
An ordinary bond's coupon is fixed while its risk is not, so a downgrade leaves the holder under-compensated. The step-up reprices the bond in the holder's favour at the moment that would otherwise happen.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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