Fixed-Income Types: Bullet, Fully Amortized, and Partially Amortized Bonds
Interest payments are nice, but bond investors definitely want the principal back.
There are multiple ways of accomplishing this. Consider the $5,000 face-value bond issued by Vanilla Cakes and Cookies. This bond of VCC is a conventional bond, which pays a 4% annual coupon, and then the principal at expiration. The tenor of the bond is five years.
Here is a payment schedule for the VCC issue:
| Year | Cash Flow | Principal Repayment | End of Year Principal Balance |
|---|---|---|---|
| 1 | $200 | $0 | $5,000 |
| 2 | $200 | $0 | $5,000 |
| 3 | $200 | $0 | $5,000 |
| 4 | $200 | $0 | $5,000 |
| 5 | $5,200 | $5,000 | $0 |
If this bond is purchased at a discount price of 97, what will be true of the coupon payments?
No.
The coupon payments in this conventional bond are fixed as shown.
No.
The coupon payments are the 4% payments of $200 per year as shown. They would not be higher based on the price of the bond; they are fixed.
Exactly!
Remember that the cash flows of a conventional bond are set in place, so a lower price creates a higher yield, but that's all. Related to this, the risk of the cash flows changes a little as well. An investor purchasing the bond at a discount would see the principal payment in five years as an even larger portion of the initial investment, so having that large, single principal payment due on the final day creates some uncertainty.
Now compare this to the bond issued by Chocolate Coffee Cakes. Its bond has the same $5,000 face value, the same 4% coupon rate, and also matures in five years. The difference is that the CCC bond is __fully amortizing__. This means that the bond provides five equal payments to investors with some principal paid each year. Here is a payment schedule for the CCC issue:
| Year | Cash Flow | Principal Repayment | End of Year Principal Balance |
|---|---|---|---|
| 1 | $1,123.14 | $923.14 | $4,076.86 |
| 2 | $1,123.14 | $960.07 | $3,116.79 |
| 3 | $1,123.14 | $998.47 | $2,118.33 |
| 4 | $1,123.14 | $1,038.41 | $1,079.92 |
| 5 | $1,123.14 | $1,079.92 | $0 |
How would you best characterize the interest and principal payments in a fully amortized bond?
No.
The payments are equal in each period, but notice that the principal paid back in each period is different. This also means that the interest paid in each period must be different.
No.
The total payments in each period are equal, and each payment is interest and principal combined. Think about what that must mean if one of the two is changing.
That's right!
Each cash flow from the issuer to the investor is of equal size. Those five equal payments are the sum of interest and principal. Since principal is repaid each period, it is logical that the interest expense would have to be getting smaller. Since the interest paid is smaller, and the total payment is the same, the principal payment must be growing.
You follow this same idea when you get a mortgage for a house or a car loan. These are amortizing loans wherein you make the same payment every month and pay back the principal and interest in varying amounts with each successive payment. __Mortgage-backed securities (MBS)__ are based on these sorts of loans; they just dice them up into repackaged pieces.
No.
Notice that the principal payments listed in each period are actually increasing.
Swirl Mixes is issuing a five-year, $5,000 bond with a 4% coupon as well, but it has decided to go with a third option. Instead of the last-minute payment of a bullet bond or the completely even payments of a fully amortized bond, the SM issue will be a hybrid: a __partially amortized bond__.
Swirl Mixes' plan is to amortize part of the principal, and then leave the rest for a balloon payment at maturity. Here is a payment schedule for the SM issue:
| Year | Cash Flow | Principal Repayment | End of Year Principal Balance |
|---|---|---|---|
| 1 | $753.88 | $553.88 | $4,446.12 |
| 2 | $753.88 | $576.04 | $3,870.09 |
| 3 | $753.88 | $599.08 | $3,271.01 |
| 4 | $753.88 | $623.04 | $2,647.97 |
| 5 | $2,753.88 | $2,647.97 | $0 |
How would you state this bond as a hybrid of two other bonds?
No.
That combination would just have cash flows of $2,000 x 4% = $80 in years one to four. Consider the fact that principal is being repaid in those early years.
No.
Consider the amount of the "extra" principal payment in year five on the schedule.
To summarize this discussion:
[[summary]]
Yes!
The payments are equal for the first four years as principal declines. But since that last payment in year five is equal to the first four payments plus an extra $2,000, it's clear that the balloon payment in year five is that extra $2,000 principal payment that was waiting all along, just like a bullet bond, while the remaining $3,000 of principal was amortized.
With partially amortized bonds and fully amortized bonds, the investor has the benefit of a little less risk. There can't be as much interest-rate risk or default risk of the principal when the investor gets some of it back in the early years.
They will be slightly smaller
They will provide the investor with a higher coupon
They will provide the investor with a higher yield
Interest payments are equal, and principal payments are equal
Interest payments are equal, and principal payments are rising
Interest payments are decreasing, and principal payments are rising
Interest payments are decreasing, and principal payments are equal
It's like a $2,000 bullet bond together with a $3,000 zero-coupon bond
It's like a $2,000 fully-amortized bond together with a $3,000 bullet bond
It's like a $2,000 bullet bond together with a $3,000 fully amortized bond
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