Thinking of investing in bonds?
Don’t know what amortization is?
We are here to the rescue!
Every investment class has its own features and it can sometimes get complicated to understand each of them. In this article, we will learn what amortization is, along with a simple example. Let’s get started!
What Is Amortization?
In simple words, amortization is the process wherein you get back your principal investment, during the tenure of the asset.
Confused? Let’ s explain further.
In the vanilla sense, when you invest in bonds, you invest a fixed sum at day 0 and receive your investments at the end of the tenure.
Let’s say Mr. Ram invests in bonds issued by the platform Wint Wealth. And let’s assume the asset is, Wint Wheels Mar21.
During the tenure of the asset, the issuer (company) will pay Mr. Ram an interest on your investment on a monthly basis.
In contrast to the normal bond structure, In covered MLD, you will receive your entire investment, along with the interest at the end of the tenure, in this case, in March 2023 . This structure is known as, ‘bullet principal and interest repayment’.
Learn more about different types of debt instruments.
What Changes With Amortization?
Let’s take an example of our upcoming asset.
Suppose Mr. Ram invests in the upcoming asset which includes the amortization feature. Here, Ram will receive some of his principal investment, during the tenure of the asset.
Let’s further understand this by an example.
Say, you have invested ₹ 100 (this is merely an example amount) in a bond at the interest rate of 10% per annum for 4 years with equal amortization at the end of each year.
This means you will receive 25% of your principal invested at the end of each year.
|Year||Opening balance||Principal||Interest @10%||Closing Balance|
(Negative since this will be the outflow at the time of your investment)
|1||₹ 100||₹ 25||₹ 10.00||₹ 75|
|2||₹ 75||₹ 25||₹ 7.50||₹ 50|
|3||₹ 50||₹ 25||₹ 5.00||₹ 25|
|4||₹ 25||₹ 25||₹ 2.50||₹ 0|
Also, we can understand from the above table that, Ram will receive an interest on the reduced principal, from 2nd year onwards, as he has already received Rs. 25 at the end of the 1st year.
Benefits of Amortization
One of the major benefits of amortization is that over the tenure of your investment, your exposure to risk is gradually reduced, which prevents you from losing your principal, in case the entity defaults.
Let’s take an example of the DHFL case, here, when the entity defaulted, the investor’s money was stuck. Now, if it had been an amortising bond, a good chunk of money would have already come back to investors before it had defaulted.
Similarly, in our first example, say if the entity had defaulted after 2 year from the date of Ram’s investment, then, the exposure has anyways reduced to ₹ 50 from the initial investment of ₹ 100.
In this situation, Ram, who has invested in a bond with an amortization structure is better off as compared to an investor who has invested in a bond with bullet principal repayment structure.
From the example above, we definitely realise that an amortizing feature can be extremely beneficial for an investor, as opposed to other features like bullet repayment. However, investors are always advisable to research on their own or talk to people regarding every investment.
If you have any more queries regarding amortization or any other structure, please feel free to reach out to us on firstname.lastname@example.org. You can also send us a message on our WhatsApp number, present on the website.