Fully Amortized Bonds: What Is It, How It Works, Calculation, Pros, Cons

A fully amortized bond is a debt security with a predetermined payment schedule. These payments, typically made monthly or annually, consist of principal and interest components. Over time, the principal portion of each payment increases while the interest portion decreases. This gradual reduction in the outstanding principal balance culminates in the complete repayment of the bond at its maturity date.

In simpler terms, a fully amortized bond is like a loan with a fixed payment schedule. Each payment towards the bond reduces the outstanding principal balance, making it a less risky investment.

Unlike other bond types, fully amortized bonds offer predictable cash flows, making them popular for investors seeking stability. The fixed payment schedule of a fully amortized bond can be particularly beneficial for individuals who require a consistent income stream.

Key characteristics of fully amortized bonds

Fully amortized bonds possess several key characteristics that distinguish them from other debt securities. Let’s examine these defining features in greater depth.

Fixed payment schedule. A hallmark of fully amortized bonds is their fixed payment schedule. Investors receive consistent payments throughout the bond’s life, simplifying budgeting and financial planning. This predictability offers security, as investors can rely on a steady income stream.

Principal reduction. Each payment allocates a portion toward reducing the bond’s principal balance. This gradual reduction in the outstanding debt minimizes the overall risk associated with the investment. As the principal balance decreases, the interest expense decreases, leading to a higher proportion of each payment going toward principal repayment.

Interest payments. The interest component of each payment is calculated based on the remaining principal balance. As the principal balance decreases, so does the interest payment. This approach ensures the bondholder gets a fair return on their investment. At the same time, the issuer gradually reduces its debt obligation.

Maturity date. A fully amortized bond has a specific maturity date, at which point the entire principal balance is repaid to the bondholder. This predetermined end date provides clarity and certainty for both the investor and the issuer. Upon maturity, the bondholder receives the final payment, including the remaining principal balance and any accrued interest.

How Fully Amortized Bonds Work

To illustrate, consider a $1,000 fully amortized bond with a 5-year term and a 6% annual interest rate. The issuer would make regular payments to the bondholder, comprising interest and principal components.

Initially, the interest portion would be higher and the principal portion lower. As time progresses, the principal portion of each payment would increase, and the interest portion would decrease. By the end of the 5-year term, the entire $1000 principal balance would be repaid.

Consider a $1,000 bond with a 5-year term and a 6% annual interest rate to illustrate the mechanics of a fully amortized bond.

Here’s a breakdown of the bond’s cash flows:

As you can see, the bondholder receives a fixed payment of $237.40 each year. However, the composition of each payment changes over time.

Initially, a larger portion of the payment goes towards interest, while a smaller portion reduces the principal balance. As the bond matures, the principal repayment portion increases and the interest payment decreases. By the end of the 5-year term, the entire $1,000 principal balance is repaid.

This predictable payment structure makes these amortized bonds popular with investors seeking a steady income stream and ensures capital preservation.

Calculating the amortization schedule

We must find the fixed periodic payment to calculate the values in the amortization schedule. This payment will fully amortize the loan over the specified period.

Step 1: Calculate the annual interest payment

• Annual interest payment = Face value * Coupon rate
  • For Year 1: $1,000 * 6% = $60

Step 2: Calculate the fixed periodic payment

We can use a financial calculator or spreadsheet function like PMT to calculate the fixed periodic payment. The formula for this is:

• PMT = P * r * (1 + r)^n / [(1 + r)^n – 1]

Where:

• PMT is the fixed periodic payment
• P is the principal amount (face value) of the bond
• r is the periodic interest rate (annual interest rate / number of periods per year)
• n is the total number of periods

For our example:

• P = $1,000
• r = 6% / 1 = 6% = 0.06 (annual)
• n = 5 years

Plugging in the values:

• PMT = 1000 * 0.06 * (1 + 0.06)^5 / [(1 + 0.06)^5 – 1] ≈ 237.40

Therefore, the fixed periodic payment is approximately $237.40.

Step 3: Calculate the principal repayment for each year

• Principal repayment = Fixed periodic payment – Interest payment

For example, in Year 1:

• Principal repayment = $237.40 – $60 = $177.40

Step 4: Calculate the outstanding balance for the next year

• Outstanding balance = Previous year’s outstanding balance – Principal repayment

For example, after Year 1:

• Outstanding balance = $1,000 – $177.40 = $822.60

Step 5: Repeat steps 1-4

Repeat Steps 1-4 for each subsequent year, adjusting the interest payment based on the new outstanding balance.

Year 2:

1. Interest payment: $822.60 * 6% = $49.36
2. Principal repayment: $237.40 – $49.36 = $188.04
3. Outstanding balance: $822.60 – $188.04 = $634.56

Year 5:

1. Interest payment: $223.96 * 6% = $13.44
2. Principal repayment: $237.40 – $13.44 = $223.96
3. Outstanding balance: $223.96 – $223.96 = $0

Benefits of fully amortized bonds

Fully amortized bonds offer several advantages, making them an attractive investment option for many individuals and institutions.

Predictable cash flows. Investors can rely on a consistent income stream from the bond’s periodic payments. This consistency makes it easier for them to budget. It also helps to plan for future expenses. This reliability is especially valuable for individuals seeking a steady source of income, such as retirees or those living on a fixed income.

Reduced risk. As the bond matures, the principal balance is gradually repaid, lowering the overall risk associated with the investment. This risk reduction particularly appeals to risk-averse investors prioritizing capital preservation over high returns.

Potential tax advantages. In certain jurisdictions, interest payments from fully amortized bonds may be tax-deductible. This can provide significant tax benefits for investors, especially those in higher tax brackets. However, consulting with a tax advisor is important to determine the tax implications of investing in fully amortized bonds.

Drawbacks of fully amortized bonds

While fully amortized bonds offer several advantages, they also come with certain drawbacks that investors should consider.

Lower yield. Due to their reduced risk profile, fully amortized bonds may offer lower interest rates than other bond types. Investors seeking higher returns may need to consider other investment options, such as corporate or high-yield bonds.

Early redemption penalties. Some issuers may impose penalties if investors choose to redeem the bond before its maturity date. This can reduce the overall return on investment and limit the investment’s flexibility.

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