IT has been said time and time again that the world of bonds is filled with invigoration and excitement. The excitement begins when one has to decide between sovereign and corporate bonds, plain vanilla or structured bond or an amortised instrument or not, just to name a few. The decision to invest in bonds presents clients with a number of options to choose from depending on their financial goal. The voyage continues as we further explore the buzz on amortised bonds.
In general terms, an amortised loan is one in which where the principal of the loan is paid down over the life of the loan according to an amortised schedule. The same concept applies with an amortised bond, in that the bond repays a part of the principal (face value) each time that the interest becomes due and payable. The amortising schedule (repayment of principal) is prepared in such a manner that the entire principal is repaid by the maturity date of the bond and the last coupon payment is done on the maturity date. This payment schedule is in contrast to the features of a regular bond where the full principal amount is repaid at maturity.
The principal amount repaid each period may vary depending on the terms and conditions of the bond schedule. In one scenario a fixed percentage of the principal could very well be calculated and repaid each period. For example, it could be stated that seven per cent of the face value will be repaid on each coupon payment date. If a client has a face value of US$10,000 he would receive US$700 on each date.
Another provision may allow for the principal payment to increase with each installment as the interest payment decreases so that the combined payment remains the same. For the following example, we will assume that the face value is US$10,000, coupon rate is eight per cent per annum with coupon payment made semi-annually and the first principal payment is seven per cent. The calculations will only be shown for the first two payment periods:
First payment — Principal repayment of US$700 ($10,000 x 7%) and interest of US$395 (10,000 x 8% x 180/365). The total amount received by the client would be US1,095 ($700 + $395)
Second payment — Principal repayment of US$728.00 ($1,095 - $367) and interest of US$367 (9,300 x 8% x 180/365). The total amount received by the client would still be US$1,095 (728 + 367). However, the principal payment would be higher in order to compensate for the lower interest being received.
The special treatment of the principal leads us to the advantages of amortised bonds. The first and most important is the investor is not overly exposed to the threat of credit risk. With a plain vanilla bond, principal is repaid in full at maturity; the real danger is the fear that the issuer may possibly be unable to pay off the debt or further have to extend the maturity date. This risk is mitigated with amortised bonds as principal is already being repaid over the life of the instrument.
Another advantage to investors holding amortised bonds would be that they are less sensitive to interest rate risk when compared to a debt with the same maturity; and coupon rate. Interest rate risk is defined as the possibility of a reduction in the value of a security resulting from a rise in interest rates. Given that the smaller payments are made in the future on amortised bonds, it becomes clearer that credit risk is mitigated.
Clients who are more geared towards income- generating; investment, would have an eye for this investment; however, not all investors have income as their top priority. Persons who have other objectives, such as capital appreciation, would be more skewed towards other types of bonds that offer the respective features they desire.
Dian Blackwood is a manager, personal financial planning with Sterling Asset Management Ltd. Sterling provides medium- to long-term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org