Cash Flows of Fixed-income Securities

Plain Vanilla or Bullet Bonds

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 for corporate bond issuances. They are also known as a 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

On the other hand, an amortizing bond has a fixed periodic payment that reduces the outstanding principal amount to zero till the maturity. Each payment goes toward payment of both interest and principal.

Likewise, 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 out the outstanding principal.

For instance, let’s 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%:

  1. For the fully amortized bond, the annual payments are constant like an annuity and include both the coupon and the principal. Over time, the interest payment decreases and the principal repayment increases.
  2. The partially amortized bond is the combination of the two elements: a five-year annuity plus the balloon payment at maturity. The sum of the present values of these two elements make-up the bond price of $1,000.

Question

Which bond structure has the least amount of capital repaid at maturity?

A. Bullet bond

B. Fully amortized bond

C. Partially amortized bond

Solution

The correct answer is B.

Fully amortized bonds have constant payments like an annuity. Over time, the interest payment decreases and the principal repayment increases.

Option A is incorrect because, for the bullet bond, the last payment is the full amount of principal with the last periodic coupon.

Option C is also incorrect as the partially amortized bonds repay a lesser amount of principal in the form of a balloon payment.

Reading 42 LOS 42e:

Describe how cash flows of fixed-income securities are structured



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