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

A partially amortized bond has a unique repayment structure. While traditional bonds fully amortize the principal over their term, partially amortized bonds pay off only a portion of the principal during this period, resulting in a balloon payment at maturity. While both bond types involve regular interest payments, partially amortized bonds have a distinct principal repayment schedule.

Why invest in a partially amortized bond?

Due to their unique structure, partially amortized bonds present an attractive investment opportunity. These bonds require smaller initial payments, making them more accessible for issuers.

Additionally, the balloon payment at maturity allows issuers to refinance or restructure their debt. Issuers often offer higher interest rates on partially amortized bonds to compensate for the risk associated with the balloon payment. These rates are higher than those on fully amortized bonds, potentially resulting in higher yields for investors.

How partially amortized bond works

You’ll receive regular, fixed-interest payments when you invest in a partially amortized bond. However, these payments primarily focus on interest, with only a small portion dedicated to reducing the principal balance. As a result, a significant amount of the principal remains outstanding until the bond’s maturity date.

To fully retire the bond, a substantial lump sum payment, known as a balloon payment, is required at maturity. This final payment covers the remaining principal balance that hasn’t been repaid through the periodic interest and principal payments.

Key characteristics

Regular interest payments. Investors receive fixed interest payments at predetermined intervals, typically monthly, quarterly, or semi-annually. These payments provide a consistent income stream for investors throughout the bond’s term. The interest rate is usually fixed for the bond’s duration, offering predictable cash flows.

Minimal principal repayment. Each periodic payment includes a small component for principal reduction, which gradually decreases the outstanding loan amount. This minimal principal repayment ensures that most of the initial loan balance remains outstanding until maturity. The specific amount of principal repaid in each payment may vary depending on the terms of the bond agreement.

Balloon payment. A significant lump sum payment is due at the bond’s maturity to repay the remaining principal balance. This final payment can represent a substantial portion of the original loan amount, often exceeding the sum of all previous principal repayments. The balloon payment introduces a significant cash flow requirement at the end of the bond’s term, which investors must plan for accordingly.

Breaking down the given amortization schedule

An amortization schedule provides details about the periodic payments and interest payments. It also shows the principal repayments and outstanding balance of a loan or bond over its entire term.

A fully amortized bond pays off the entire principal over its life. In contrast, a portion remains unpaid until maturity for partially amortized bonds, which is known as the balloon payment.

Consider a partially amortized bond with the following characteristics:

• Face value: $1,000
• Coupon rate: 7%
• Maturity: 5 years
• Balloon payment: $300

Cash flow schedule:

To understand how we arrive at the figures in the partially amortized bond example, let’s break down the calculations:

Calculating the annual payment

1. Present value of the balloon payment:
   • We discount the $300 balloon payment back to the present using the implied interest rate (calculated from the given cash flows):
   • PV_balloon_payment = Balloon payment / (1 + Coupon rate)^ Maturity  = $300 / (1 + 7%)^5 =  $213.90
2. Present value of the remaining principal payments:
   • We subtract the present value of the balloon payment from the total principal amount:
   • PV_remaining_principal = Face value – PV_balloon_payment = $1,000 – $213.90 = $786.10
3. Annual payment calculation:
   • We calculate the annual payment using the present value of the remaining principal payments and the annual coupon payments:
   • Annual_payment = (PV_remaining_principal) / ((1 – (1 + Coupon rate)^(-5)) / Coupon rate) = ($786.10) / ((1 – (1 + 7%)^(-5)) / 7%) = $191.72

Calculating outstanding balance and principal repayment

1. Year 1:
   • Interest payment: Outstanding balance * Coupon rate =  $1,000 * 7% = $70
   • Principal repayment: Annual payment – Interest payment = $191.72 – $70 = $121.72
   • Outstanding balance: Previous outstanding balance – Principal repayment = $1,000 – $121.72 = $878.28
2. Year 2:
   • Interest payment: Previous outstanding balance * Coupon rate =  $878.28 * 7% = $61.48
   • Principal repayment: Annual payment – Interest payment =  $191.72 – $61.48 = $130.24
   • Outstanding balance: Previous outstanding balance – Principal repayment = $878.28 – $130.24 = $748.03
3. Year 5:
   • Interest payment: Previous outstanding balance * Coupon rate =  $459.55 * 7% = $32.17
   • Principal repayment: Balloon payment + Annual payment – Interest payment = $300 + $191.72 – $32.17= $459.55
   • Outstanding balance: Zero = Previous outstanding balance – Principal repayment = $459.55 – $459.55 = 0
   • Cash flow: Balloon payment + Annual payment = $300 + $191.72 = $491.72

Note: We need to use financial calculator functions to accurately calculate the implied interest rate. We can also use spreadsheet software like Excel to get the exact figures.

Pros and cons of partially amortized bonds

It is crucial to consider the potential risks and rewards carefully before investing in a partially amortized bond. Investors should assess their risk tolerance, conduct thorough research on the issuer’s financial health, and understand the specific terms of the bond.

Pros

Lower initial payments. Smaller principal payments during the bond’s life can make it more affordable for issuers. This is particularly true for those with limited cash flow in the early years of the bond’s term.

The balloon payment at maturity provides flexibility for issuers. It allows them to refinance or restructure their debt, enabling them to adapt to changing market conditions and financial needs.

Potential for higher yields. Issuers may offer higher interest rates on partially amortized bonds. This compensates for the risk of the balloon payment. These rates are compared to those on fully amortized bonds.

Cons

Balloon payment risk. The large balloon payment at maturity can pose a significant financial burden for the issuer. If the issuer cannot meet this payment, it may default on the bond. This situation could lead to potential losses for investors.

Interest rate risk. Changes in interest rates can impact the value of your bond. If interest rates rise, the value of your bond may decrease, and vice versa.

Credit risk. The creditworthiness of the bond issuer is a critical factor. A lower credit rating indicates a higher risk of default.

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