Lesson 2 of 7 · 13 min
Sinking funds, waterfalls, zero-coupon and deferred coupon bonds
Sinking funds retire a bond bit by bit, waterfalls decide which investor class gets principal first, and zero-coupon and deferred coupon bonds push interest toward maturity.
In short
- A sinking fund sets aside money over time to retire part of a bond early on agreed terms, lowering credit risk but adding reinvestment risk.
- Retirement can be by random redemption through the trustee or by repurchase at a fixed price.
- A waterfall pays interest to all classes but principal sequentially: the most senior tranche first.
- Shortfalls hit the most junior tranche first, so senior tranches carry the least credit risk.
- Zero-coupon bonds pay no coupon; the discount to par is cumulative interest, and there is no coupon reinvestment risk.
- Deferred coupon bonds pay nothing at first and a higher coupon later; they usually trade below par.
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