Bank deposits, mutual funds, stocks, futures and options – investors are always looking for new avenues of investment. There is a wide range of security alternatives available depending on the associated risks and the investment period. However, with a fixed income stream and capital appreciation of the investment, the security of their capital 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 traditionally been viewed as a “safe” way to invest money. This blog highlights the importance of amortized bonds as a contemporary investment alternative. Amortized bonds have recently gained in popularity due to their ability to provide systematic returns and return of capital to investors. Let’s briefly discuss the definition of obligations and related terms.
What are Bonds?
Bonds are loan agreements between the issuer and the holder, which detail the terms of payment (debt service) and the due date. These have a nominal value (principal) to be repaid at maturity and can be issued at a discount or a premium.
Bonds are fixed-term debt securities issued to finance specific projects by the issuer. Interest (based on the coupon rate) is paid in pre-defined installments to the bond holder until maturity. Bond prices are inversely proportional to market interest rates and depend on various factors such as the credibility of the issuer, maturity and market interest rates.
Characteristics of bonds
Banks and other financial institutions generally meet the financing needs of the market. However, the value of the loans they can offer is limited and they have to comply with certain regulatory standards. This is where the obligations come in.
Bonds are usually issued by government or large corporations for their huge capital needs. These are either listed on the stock exchange or over-the-counter. Bonds originally had fixed interest rates, which is why they were called fixed income instruments. Nowadays, variable or floating interest rates are also quite common. The advantages involve:
- Bonds are a good way to offset fluctuations in riskier investment avenues, such as stocks and derivatives.
- Often, bonds provide a secure cash flow throughout their life, while preserving all of the capital invested.
The most important feature of bonds is that they are instruments tradable in the secondary market and often attract investors looking for safer and more secure investment options.
What are face values?
Also known as face value, face value is the value of the business as it appears on its books and share certificates. It is set by the company as soon as it decides to issue its shares and bonds. There are no specific criteria for setting the par value of shares by a particular company. As a rule, they are assigned arbitrarily by the company.
What is an amortized bond?
Amortized bonds are bonds where, instead of paying the full face value on maturity, regular payments as well as interest are received. This can be considered synonymous with paying IMEs on a loan. Amortized bonds may have different amortization schedules that allow for the depreciation / payment of the face value of the bond over its life. Amortization schedules define the amount of interest expense, interest payment, discount, or premium amortization for each payment.
Amortized bonds differ from balloon / bubble / bullet bonds in the way the principal value is repaid. Balloon bonds, as the name suggests, involve a lump sum payment of principal at the end of the maturity period. Whereas with amortized bonds, the principal is repaid over the life of the bond, often in varying proportions. Usually, the initial period involves a higher proportion of interest payment due to the full payment of the principal outstanding. Finally, as the principal delinquency decreases, the proportion of interest in periodic payments also decreases.
In the event that the bonds are issued at a premium (above the nominal value) or are purchased at a premium after issue, the amortized bond premium will be calculated by:
- Calculate the bond premium (Carrying Amount-Nominal Value) and divide it by the number of payments pending before the bond matures; WHERE
- The amortized bond premium can be calculated by subtracting the product of the bond face value and the coupon rate from the product of the bond market price and the market interest rate.
A general categorization of obligations
There are roughly five categories of bonds:
1.Based on transmitter:
- Businesses – Issued by businesses due to more favorable borrowing terms.
- Government (Sovereign) – Issued by a country’s treasury / central bank and are also known as T-bonds / G-secs.
- Municipal – Issued by state governments / municipalities.
- Agency – Issued by organizations affiliated with the government.
2.Based on taxation:
- Taxable – These attract taxes, often payable as LTCG when due.
- Tax Exempt – These do not attract taxes.
3.Based on maturity term:
- Short term – Mature in 1-5 years.
- Intermediate-Term – Maturity in 5-10 years.
- Long term – Mature in 10-30 years.
- Series – Mature gradually, with varying terms of maturity.
- Perpetual / Consolidation / Perp – They have no maturity date and are often understood more as equity than a debt instrument.
- Callable – Accompany a reimbursement clause by the issuer.
4.Based on purpose:
- Mortgage – Accompany a claim on the real estate used as collateral.
- Subordinated – Redeemed after preferential / primary bonds in the event of liquidation of the issuer.
- Bearer – Claimed by any person carrying the document of a surety.
- 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 – Offers fixed preset coupon rates.
- Floating / Amortized – Offers floating coupon rates.
- Zero – No coupon rate.
- 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 book value or price of the bond, the interest charge over its life will be 9000×10% = Rs.900. Assuming the payments are made annually, the fixed payments will be 9900/30 = Rs. 330. From now on, the annual debt service will have 300 rupees as the main component, while 30 as the interest component.
In reality, the payments remain the same while the proportions of principal and interest vary according to the book value which varies each year. Since the book value at the beginning is high, the interest should also be high. In the example above, this will be Rs.300 (9000×10%), while the remaining Rs.30 will be the principal repayment. The repayment schedule is then determined accordingly.
Benefits of the amortized obligation
Bond amortization is the systematic and progressive depreciation of the purchase value of an intangible asset with a limited life. Such bonds are an accounting hack for the issuer because the total debt keeps decreasing over time while its benefits are used as an asset. Since the higher debt service is a non-operating expense, it can be used to report lower pre-tax profit. If a bond is issued at a discount (lower than its face value), the discount charges may be amortized in the form of interest charges. If the bond is issued with a premium, the bond’s premium can be deducted from the current tax year if the interest expense is exempt from tax. The same can be amortized and adjusted for interest payable if the interest charges are taxable.
Companies opt for loan amortization because it helps reduce some fundamental risks associated with investing. These risks include:
- Reduce the overall credit risk, because the outstanding amount is deductible and the risk of default is minimized.
- Fluctuations in interest rates impact long-term loans the most. But, since most of the interest is paid / accrued over the initial term of the bond, the interest risk later in the life of a bond is reduced.
- There is predictability of cash flow for the investor, as other markets are subject to higher fluctuation risks, and the purpose of these debts is backed by a reliable authority / institution.
- Investment ratings on these bonds are also more achievable for amateur investors. Therefore, it could be a great investment alternative for investors looking for a safe investment option and security of capital.
What are the two types of amortized bonds?
Depending on the method of calculating the installments, there may be 2 types of amortized bonds:
Straight-line depreciation method: This is when all payments have the same value. Interest expense is calculated by adding the amortized amount to the interest payment in the event of a discount. It is subtracted in the event of a premium.
Effective interest rate method: This is when the calculated interest expense subsequently changes and is based on the difference between interest income and interest payable.