Understanding Amortised Bonds and Their Benefits
If you are a risk-averse investor, it is best to opt for debt instruments offering predictable payouts and relatively better risk-adjusted returns. Bonds, in particular, are one of the most popular debt instruments available in the market.
In this article, we aim to understand amortised bonds and their benefits. But before learning more about amortised bonds, let’s get some quick context on what bonds are and how they work.
You can define bonds as loan agreements between the holder and the issuer. Bonds are debt instruments that a corporation or a government issues to raise money. The details of the debt servicing or repayment terms till the investment matures are fixed at the time of issuance of the bond.
When you make a bond investment, you invest a certain amount called face value, which the issuer needs to repay along with interest determined at the time of the issue. A vital feature of a bond is that its price is inversely proportional to the ongoing market interest rate. Moreover, the bond price is also influenced by factors such as the issuer’s credibility and maturity time.
What is the Face Value of a Bond?
In financial terms, you can define face value as the nominal or rupee value of a particular security, as given by the issuer. In terms of bonds, face value is the amount that needs to be repaid when the investment matures. The face value of a bond is also known as par value.
As we saw earlier, the bond prices are inversely proportional to the interest rates. It implies that if the interest rates go up, the bond’s price decreases and vice versa. This feature becomes critical when the bonds are bought or sold in the secondary market. Let’s understand this better through an example.
Suppose you purchase a bond at face value of Rs.1,000. The coupon rate of the bond is 5%, and the maturity is five years. Hence, if you hold on to the bond till it matures, you will earn an annual interest of Rs. 50 until maturity. However, if the current interest rate in the market goes down to 4%, the new buyers will prefer to buy the bond that offers a higher coupon rate compared to current interest rate in the market.
Consequently, the price of the bond you own will go up in the secondary market as ideally there won’t be any buyer to buy it at face value. Thus, if you decide to cash on the opportunity, you will sell the bond at a premium (above face value). Similarly, if the current interest in the market goes up to 6%, there will be a lower demand for bonds with a 5% coupon rate. The bond will then be sold at a discount (below face value).
You must note that the face value of a bond doesn’t denote the underlying market value of the security. The latter is generally determined by the demand and supply principle. With this essential context, let us now learn more about amortised bonds.
Understanding Amortised Bonds
Amortised bonds are those bonds in which the borrower pays you the face value at regular intervals along with the interest payments. Thus, instead of paying the entire face value at maturity, the issuer pays you regular instalments of the invested amount.
These amortised bonds can offer varying amortisation schedules that allow writing down the bond’s face value over its tenure this will essentially help you in reducing risk as the invested principal will be recovered during the tenor of bond. Moreover, these schedules also have a say in deciding the interest expense, amortisation premium, interest, or discount for each payout.
The amortised bonds are different from the regular bonds. The difference is how the bond issuer decides to repay the face value at maturity. You receive a lump sum for regular bonds when the bond matures. On the other hand, for the amortised bonds, the principal amount is paid at regular intervals. The proportional payment of the principal may vary depending upon the terms and conditions.
Thus, from the example above, each payment you receive from the issuer will have two components. One will be the interest component, and the other will be the repayment of the principal amount. Eventually, as the principal amount decreases, so does the proportion of the interest payout. And throughout the bond’s tenure, the regular payouts will settle the principal amount.
Such an amortisation schedule, wherein the bond’s principal amount is paid in equal instalments over the tenure, is called a fully amortised bond. In this, the amount is paid entirely by the date of maturity. On the other hand, there is another form of an amortised bond, called a partially amortised bond. As you may have guessed, only a specific (partial) portion of the bond is amortised over the tenure.
The amortisation follows a similar payment structure as discussed above. The remaining principal amount is paid when the bond matures. You can describe a partially amortised bond as a hybrid between a fully amortised bond and a normal bond.
Example of bond amortisation
Let’s understand the amortisation of bonds through an example.
Suppose you purchase a bond at face value of Rs.10,000 with an interest rate of 10%. The tenure of the bond is 4 years. For ease of calculations, we will assume the investment to be a fully amortised bond and payments are made yearly. We can use online amortisation calculators to come up with the numbers.
As the bond is amortised in nature you will receive accrued interest and the part of principal at the time of each scheduled payout. Generally principal amount is paid back in equally as specified in the table below
|Interest component||Principal component||Yearly payout|
Benefits of Amortised Bonds
For the companies or governments issuing bonds, it becomes an intangible asset with a fixed tenure. Amortisation of bonds helps the issuer to decrease the bond’s cost price gradually.
Another significant benefit for issuers is that the amortisation of bonds considerably lowers the credit risk of the loan as the principal amount is being paid over the bond tenure. Moreover, it also reduces the bond’s interest rate risk compared to a common bond with a similar term and rate of interest. This is due to the fact that the interest component goes down with the lower weighted-average maturity of the cash flows.
Amortised bonds are a good investment option with reduction in the potential loss which may occur due to default risk. If the bond is fully amortised, you also mitigate the interest rate risk that may affect your bond value. You can opt for amortised bonds depending on your investment horizon and financial goals. As always, consult with your financial adviser before making any investment-related decisions.
FAQs about Amortised Bonds
What are the types of amortised bonds?
Fully amortised bonds and partially amortised bonds are the two types of amortised bonds.
What is straight-line bond amortisation?
The straight-line amortisation is a way of calculating debt repayment. Its main characteristic is the fact that it allocates the same amount of interest for each payment until the debt is repaid. It does so by dividing the total amount of owed interest by the number of payments that need to be made.
What is the effect of bond amortisation?
Amortised bonds allow issuers to repay principal with interest in the regular payout during the bond’s tenure. It helps the issuer gradually lower the bond’s cost price.