What are Amortised Bonds?
Apart from a regular bond, another type of bond is known as an amortised bond. In this type of bond, the face value (principal amount of the bond) and the interest are gradually paid off over the bond’s tenure. This minimises the issuer’s risk of defaulting on the invested amount and offers the bondholders a promise of safe investment
Thus, an amortised bond has a lower risk factor than a regular bond. Apart from providing a recurring cash flow, they also have other benefits. There are various ways to calculate amortisation. You can learn all about amortised bonds in detail below.
Key Highlights
- An amortised Bond is a type of bond in which the bond issuers pay off the loan amount by making fixed periodic payments that include the principal and the interest component.
- They are different from regular bonds that provide the principal amount at the end of the bond’s tenure.
- There are two methods to calculate the amortisation namely the straight-line method and the effective interest rate method. The latter method is complex while the prior method is simple.
- Amortised bonds are financially rewarding as the principal amount is gradually paid off to the investor over the bond’s tenure.
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Understanding Amortised Bonds
Let us assume that you took a loan from the bank. While taking the loan, the principal amount, the rate of interest, and the amount of the monthly instalment are fixed. On top of that, the time for which you have to continue these instalments is also fixed. Now let’s flip the situation and think that the bank has taken a loan from you and they will repay it just like you would. This is exactly how amortised bonds work.
In a regular bond, the bond issuer pays the bondbearer an interest until the maturity date. On the maturity date, the bond bearer is repaid the lump sum face value (the principal amount) of the bond. In the case of an amortising bond, instead of repaying the entire principal at the maturity date, the bond issuer makes periodic payments that include the principal amount and the interest amount. Over time, the principal component increases while the interest component decreases until the fully invested amount is repaid. This way, the bondbearer does not have to wait till maturity to receive the invested amount.
The process of paying the principal amount over time is known as amortisation. There are various methods to calculate bond amortisation. Let’s take a look at those methods.
Methods of Bond Amortisation
Now, when a bond is issued at a higher price than its price value, the excess amount is called a bond premium. On the flip side, when a bond is issued at a lower price as compared to its face value, the deficit amount is called a bond discount. Amortisation is the process of gradually paying off the premium or the discount over the bond’s tenure. There are two methods to calculate amortisation.
- The Straight Line Method
This is a simple method of calculating amortisation value. In this method, the premium or discount amount is evenly spread across each period over the bond’s tenure. In mathematical terms,
Amortisation = Bond Premium or Discount / Number of periods.
Example.
Let us assume that a bond is issued at a premium of Rs. 5000, and the bond matures in 5 years while paying interest annually to the bondholders. Thus,
Amortisation = 5000/5 = Rs. 1000.
The annual amortisation of the bond would be Rs. 1000.
- The Effective Interest Rate Method
This is a complex method of calculating amortisation value. It is based on the bond’s issue value and the market’s rate during bond issuance. In simple terms, this method uses a predetermined interest rate to calculate the principal amount and the interest amount of each payment, with the interest portion decreasing as the principal amount increases. In mathematical terms,
Interest Expense = Bond issue value * Effective interest rate.
Amortisation = Coupon Payment – Interest Expense.
In short, both methods can be used to calculate bond premiums or discounts. The latter method is more accurate and commonly used in financial reports.
Example of Bond Amortisation
Let’s take an example to understand how bond Amortisation works. Suppose a company issues an amortised bond with the following specifications:
- Face value (principal value): Rs. 1,00,000.
- Coupon Rate/Interest rate: 10%.
- Tenure of the bond: 5 years.
- Interest payment frequency: Annual (once a year).
As per the above explanation, the bond issuer has to pay a fixed amount that includes the principal and the interest component. The fixed annual payment (Amortisation value) can be calculated with the below formula.
Fixed Payment = (Face Value * Coupon Rate)/ 1 – {(1+Coupon Rate)^-(Bond Tenure)}
With the numbers we have, the fixed value comes out to be ₹26,379.88. Thus the bond issuer will make a fixed payment of Rs. 26, 379.88. This includes the principal and the interest component.
Thus the year one breakdown would look something like this:
- Interest payment: 10% of ₹1,00,000 = ₹10,000
- Principal repayment: ₹26,379.88 (total payment) – ₹10,000 (interest) = ₹16,379.88
After the first year:
- Interest paid: ₹10,000
- Principal repaid: ₹16,379.88
Remaining principal: ₹1,00,000 – ₹16,379.88 = ₹83,620.12
The year two breakdown would look like this:
- Interest payment: 10% of ₹83,620.12 = ₹8,362.01
- Principal repayment: ₹26,379.88 – ₹8,362.01 = ₹18,017.87
After the second year:
- Interest paid: ₹8,362.01
- Principal repaid: ₹18,017.87
Remaining principal: ₹83,620.12 – ₹18,017.87 = ₹65,602.25
When we continue the above calculation up to 5 years, the remaining principal would be Rs. 0. Meaning that the bond issuer would have paid off the bond bearer’s investment.
Benefits of Amortised Bonds
Like every investment, an amortised bond has various benefits. Some of them are mentioned below.
- Lower Risk to Bondbearers
The periodic payments of both principal and interest leave the issuer with less outstanding debt. This reduces the risk of the issuer defaulting on the invested amount. This also means that the bondholder’s risk of losing the entire principal in the end is reduced.
- Steady Cash Flow
The regular payment of interest and principal components from the bond issuers provides investors with a predictable source of income over the tenure of the bond.
- Improved Financial Planning
Investors and issuers get a chance to plan their finances due to the predictable payment schedule.
Conclusion
Amortised bonds are a type of bond in which the issuers repay the principal and the interest with periodic payments until the maturity of the bond. Unlike regular bonds, which allow the investor to recover their investment at the end of the bond’s tenure, an amortised bond repays the investor before the bond’s maturity.
The are two methods to calculate the amortisation amount namely, the straight-line method and the effective interest rate method. The latter provides more precision of the amount. These types of bonds are beneficial for investors as they provide a steady source of income at a low-risk rate.
FAQs on Amortised Bonds
The two types of amortised bonds are the straight-line method of amortisation and the effective interest rate method of amortisation.
Yes. Bonds that are issued at a premium or discount have to be amortised. Amortisation is the process of dividing the premium or discount over the bond’s tenure. This is done to ensure that the bond's payment of interest decreases over time.
There are two methods to calculate amortisation. The first one is called the straight line method and the second method is called the effective interest rate method.
Amortisation is an expense (non-cash), and not an asset. It is an expense that is recorded in the company’s income statement.