Understanding Credit Risk
Credit risk arises when there is a potential for a borrower to default... Read More
The most common payment structure is a plain vanilla bond with periodic, fixed coupon payments and a lump-sum payment of principal at maturity. Plain vanilla bonds are very common for government and corporate bond issuances. They are also known as bullet bonds because payment of principal occurs at maturity.
Consider a $1,000 face value 5-year bond with an annual coupon rate of 10%. With a bullet structure, investors would anticipate the following payment structure:
$$
\begin{array}{l|c|c|c|c|c}
\textbf{Year} & 1 & 2 & 3 & 4 & 5 \\
\hline
\textbf{Payment} & \$100 & \$100 & \$100 & \$100 & \$1,100 \\
\end{array}
$$
Fully Amortized and Partially Amortized Bonds
An amortized bond has a fixed periodic payment that reduces the outstanding principal amount to zero till maturity. Thus, each payment goes towards the payment of both interest and principal.
A partially amortized bond includes fixed periodic payments until maturity, but only a portion of the principal is repaid. Thus, a balloon payment is required at maturity to clear the outstanding principal.
Let’s, for instance, work with our earlier example where an investor pays $1,000 to purchase a five-year bond that pays an annual coupon rate of 10%.
Question
Which bond structure has the least amount of capital repaid at maturity?
- Bullet bond.
- Fully amortized bond.
- Partially amortized bond.
Solution
The correct answer is B.
Fully amortized bonds have constant payments like an annuity. Over time, the interest payment decreases while the principal repayment increases.
A is incorrect because, for the bullet bond, the last payment is the full amount of principal with the last periodic coupon.
C is also incorrect as the partially amortized bonds repay a lesser amount of principal in the form of a balloon payment.