What are Amortized Bonds?

Bank deposits, Mutual Funds, Stocks, Futures, and Options– investors always seek new investment avenues. There is a wide range of security alternatives available based on the risks associated and the period of investment. However, along with a fixed stream of income and capital appreciation of the investment, the safety of their principal is vital. This is where bonds have proven to be a trusted asset class for decades.

Bonds are certificates/letters given in exchange for simple/complex loans. They have been traditionally considered a ‘safe’ way of investing money. This blog highlights the significance of amortized bonds as a contemporary investment alternative. Amortized bonds have recently gained popularity due to their ability to provide systematic returns and principal repayment to investors. Let’s briefly discuss the definition of bonds and related terms.

What are Bonds?

Bonds are loan agreements between the issuer and holder, which details the terms of payment (debt servicing) and maturity. These come with a face value (principal) to be repaid on maturity and can be issued either at a discount or a premium.

Bonds are fixed-tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined installments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and dependent on various factors such as the credibility of the issuer, maturity, and interest rates in the market.

Features of Bonds

Banks and other financial institutions usually cater to the financing needs in the market. However, the value of loans they can offer is limited and they have to abide by certain regulatory norms. This is where the bonds come into the picture.

Bonds are typically issued by the government or large corporations for their huge capital needs. These are either publicly traded or over-the-counter. Bonds originally came with fixed coupon rates, which is why these were called fixed income instruments. Nowadays, variable or floating interest rates are also quite common. The benefits entail:

  1. Bonds are a good way of setting off the fluctuations in riskier avenues of investments, such as equities and derivatives.
  2. Often, bonds provide a secure stream of cash flows throughout their life, while also preserving the entire capital invested.

The most important feature of bonds is that these are tradable instruments in the secondary market and often attract investors looking for safer and secure investment options.

What are Face Values?

Also known as a par value, face value is the value of the company as listed in its books and share certificates. It is fixed by the company, once it decides to issue its shares and bonds. There are no specific criteria for fixing the face value of shares by a particular company. Typically, they are arbitrarily assigned by the company.

What is an Amortized Bond?

Amortized bonds are bonds where instead of paying the entire face value at maturity, regular payments along with interest are received. This can be considered synonymous with paying EMIs on a loan. Amortized bonds can have different amortization schedules which allow writing down/payment of face value of bond over its life. Amortization schedules define the amount of interest expense, interest payment, discount, or premium amortization for every installment.

Amortized bonds are different from balloon/bubble/bullet bonds in the way the principal value is repaid. Balloon bonds, as indicated by the name, involve lump sum payment of principal at the end of the maturity period. Whereas, with amortized bonds, the principal is repaid throughout the life of the bond, often in varying proportions. Usually, the initial period involves a higher proportion of interest payment due to the full principal payment outstanding. Eventually, as the outstanding principal decreases, so does the proportion of interest in the periodic payments.

In case the bonds are issued at a premium (over and above the face value) or are bought at a premium after issue, then the amortized bond premium shall be calculated by:

  • Calculating the bond premium (Carrying amount-Face value) and dividing the same by the number of installments pending before maturity of the bond; OR
  • The amortized bond premium can be computed by subtracting the product of bond face value and coupon rate from the product of bond market price and market interest rate.

A General Categorization of Bonds

There are broadly five categories of bonds:

  1. Based on the Issuer:

    • Corporate -Issued by companies due to more favorable terms of borrowing.
    • Government (Sovereign) - Issued by a country’s treasury/central bank and are also popularly known as T-bonds/G-secs.
    • Municipal -Issued by the state governments/municipalities.
    • Agency - Issued by government-affiliated organizations.
  2. Based on the Taxability:/h4>

    • Taxable - These attract taxes, often to be paid as LTCG at maturity
    • Tax-exempt - These do not attract taxes.
  3. Based on the Maturity term:

    • Short Term - Mature in 1-5 years.
    • Intermediate-Term - Mature in 5-10 years.
    • Long Term - Mature in 10-30 years.
    • Serial - Mature in a phased manner, with varying maturity terms.
    • Perpetual/Consolidation/Perp - They do not have a maturity date and are often understood more like equity rather than a debt instrument.
    • Callable - Accompany a clause of redeemability by the issuer.
  4. Based on Purpose:

    • Mortgage - Accompany a claim on the real estate used as collateral.
    • Subordinated - Paid back after preferential/primary bonds in case of liquidation of the issuer.
    • Bearer - Claimed by anyone bearing the document of a bond.
    • Climate - Used to specifically counter the adverse effects of climate change.
    • War - Specifically used to fund an ongoing/perceived war.
  5. Based on Interest:

    • Fixed/Bullet - Carries fixed predefined coupon rates.
    • Floating/Amortized - Carries floating coupon rates.
    • Zero - No coupon rates.
    • Inflation-linked - Carries lower coupon rates, which are adjusted with inflation rates.

How do Amortized Bonds work?

Suppose Company X issues an amortized bond for Rs.9000 (at par), for 30 years, i.e. a long-term bond. The coupon rate is 10%. Since interest is calculated on the carrying value or the price of the bond, the interest expense over its life will be 9000x10%=Rs.900. Assuming that the payments are made annually, the fixed installments shall be 9900/30=Rs.330. Now the annual debt servicing will have Rs.300 as the principal component, while 30 as the interest component.

Realistically, the installments continue to be the same while the principal and interest proportions vary as the carrying amount varies every year. Since the carrying amount at the beginning is high, the interest should also be high. In the above example, it will be Rs.300 (9000x10%), while the remaining Rs.30 will be principal repayment. The repayment schedule is then determined accordingly.

Benefits of Amortized Bond

Bond amortization is the systematic and gradual writing down of the cost value of a limited-life intangible asset. Such bonds are an accounting hack for the issuer, as the total debt keeps decreasing over time, while its benefits are being availed as an asset. The higher debt-servicing being a non-operating expense can be used to report lower earnings before tax. If a bond is issued at discount (lower than face value), the discount expense can be amortized in the form of interest expense. If the bond is issued at a premium, the bond premium can be leveraged as a deduction in the current tax year if the interest expense is tax-exempt. The same can be amortized and adjusted against interest payable if the interest expense is taxable.

Companies opt for amortization of loans as it helps curb some fundamental risks of investing. These risks include:

  • Reducing the overall credit risk, as the outstanding is deductible and the risk of default is minimized.
  • The fluctuations in interest rates impact long-term loans the most. But, since the major chunk of interest is paid off/accrued in the initial term of the bond, the interest risk later in a bond’s life gets reduced.
  • There exists predictability of cash flows to the investor, as other markets are subject to higher fluctuation risks, and the purpose of such debts is backed by some reliable authority/institution.
  • The investment ratings on such bonds are also more feasible for amateur investors. Hence, it could be an excellent investment alternative for investors looking for a safe investment option and security of principal money.
Frequently Asked Questions Expand All

Based on the way the instalments are calculated, there can be 2 types of amortized bonds:

  1. Straight-line method of amortization: This is when all instalments are of the same value. Interest expense is calculated by adding the amortized amount to the interest payment if there is a discount. It is subtracted in the case of premium.
  2. Effective-interest rate method: This is when the interest expense computed varies subsequently and is based on the difference between interest income and interest payable.