Amortised bonds explained
To understand what an amortised bond means you need to know what a bond is. A bond is a type of debt instrument or loan agreement between the issuer and holder. This loan encompasses two elements: principal and interest. An amortised bond can be explained as a bond that carries repayment of interest and the principal amount.
However, the composition of repayments in an amortised bond may not weigh equally on the principal and interest. At the start of repayments, it’s likely that the amount is skewed towards interest obligations. When the bond is closer to maturity, the instalments would hold a higher percentage of the principal repayment.
What makes amortisation bonds unique?
The basic premise of what an amortisation bond is and how it differs from other types of bonds depends on how the principal debt is repaid.
For example, in a balloon bond, the principal amount is repaid through a lump sum payment at the end of the bond’s maturity period. The regular instalments paid toward a balloon bond usually only include interest repayments. However, albeit in varying proportions, amortisation bond repayments include both the principal amount and interest.
Benefits of amortised bonds
Accounting hack: Typically applicable to companies. Regular repayments toward the principal amount reduces liabilities while benefits continue to be availed as assets. Additionally, debt-servicing costs are tagged as a company’s non-operating expenses, which can help in reducing lower earnings and tax obligations.
Credit risk: An amortisation bond reduces the credit risk. This is because the principal amount is being paid back regularly, reducing the risk of defaulting.
Reduces sensitivity: In an amortised bond the highest portion of the amount paid goes to interest payments. This helps reduce the overall duration or interest rate risks associated with a regular bond.
Types of amortisation bonds
When a bond is issued, at times the issuer may offer it at a discount to its par or face value. This discount can be amortised through the life of a bond under two commonly used methods:
Straight-Line Method: Under this, the amortisation value of the discounted bond is kept equal throughout the maturity of the bond.
Effective-Interest Method: In an effective-interest method, the amortisation value will vary throughout the bond’s life. By considering the present value of the bond’s total cash payouts, the effective-interest method calculates and applies different interest amounts to account for the amortisation pay-down.
Have you ever asked yourself “what is interest?”. The short answer to this question is that...
Bonds are an important asset class in financial markets that are often used in a diversified...
A loan is money lent to you so that you can buy something, for example a car, a house or a...