Bonds are often a top choice of investment for almost all investor classes. This is because of the lower risk element involved when it comes to bonds.
There are numerous types of bonds, which are commonly used. Amortized Bonds and Bullet Bonds are two of the most important bond types that are most commonly used today.
Bullet Bonds are referred to as standard bonds, which are known to make periodic interest payments, in addition to repayment of the principal amount at the maturity of the bond.
They are not amortized in terms of principal payments and involve principal to be repaid in a lump sum form at the end of the bond maturity.
A Bullet Bond is defined as a type of non-callable bond in which the entire principal is mostly paid in a lump sum form, on the bond’s maturity date.
They are normally known to carry a lower interest rate because of the fact that they include a high-risk exposure on the part of the debt-issuer.
In this aspect, both the government, as well as corporations are known to issue bonds with a variety of maturities.
Bonds are very frequently issued by various different entities and are classified as both, short-term, as well as long-term.
A bullet bond (or a bullet portfolio) is considered to be of a high-risk element as compared to amortizing bonds because of the fact that it gives the issuer the option to go for a large payout option.
This implies that the bond owner can opt for a large repayment obligation on a single date as compared to getting smaller payments that are spread across multiple different dates.
In this regard, issuers who are considered to be new to the investor market, or do not have a very convincing credit rating are likely to attract investors with an amortizing bond as compared to a bullet bond.
Therefore, bullet bonds are not always the top choice for investors, or for issuers because of the high level of risk involved.
Consequently, bullet bonds are considered to be more expensive from the perspective of the investor as compared to other equivalent bonds because, in bullet bonds, the investor is protected against a bond call. This holds true in periods of falling interest rates.
How Bullet Bonds work?
As mentioned earlier, it can be seen that bullet bonds work on the premise of lump-sum payments, as opposed to periodic payments over the course of time. However, pricing bullet bonds is quite different from normal bonds.
A bullet bond cannot be redeemed before the maturity date. This means that there are not callable. Therefore, they are normally known to pay a relatively lower interest rate because of the issuer’s interest rate exposure.
Furthermore, a bullet bond is also considered to be of high risk, as compared to an amortizing bond. This is because of the fact that it involves a larger payment obligation on a single date as compared to payment of smaller interest rate payments.
Pricing of Bullet Bonds
Pricing a bullet bond involves two main components:
- Total Payments for every period the payment is made
- Discount rate (bond yield)
Using these two parameters, the following formula is used to calculate the price of the bullet bond:
Present Value = Pmt / (1 + r) ^ p, where
- Pmt = payment
- R = bond yield
- P = payment period
The above example is of bond pricing in the case where the bond renders bond payments on a yearly basis. Otherwise, in the case of semi-annual compounding, the following formula is used:
Present Value = Pmt / (1 + r/2) ^ p.
Example of Bullet Bond Pricing
The pricing of bullet bonds is further explained in the following illustration:
Let’s assume a bond has a par value of $100. It has a coupon rate of 3%, whereas, the yield of the bond is 10%. The bond holds coupon payments semi-annually.
This continues for a period of 4 years. Therefore, there is 8 total period. For 7 of the periods, only the coupon rate of 5% (or $5) is paid. For the last payment period, the coupon of $5 is paid, in addition to the $100 principal.
Therefore, in this regard, the price of the bullet bond needs to be calculated by calculating the present value of payments that are made in every period. Subsequently, all payments are added together in order to arrive at the price of the bullet bond. This is illustrated below:
|Period||Payment||Present Value of the Payment|
|Period 1||$5||Present Value = Pmt / (1 + r/2) ^ p = $5 / (1 + (0.1/2))^1 = 4.8|
|Period 2||$5||Present Value = $5 / (1 + (0.1/2))^2 = 4.5|
|Period 3||$5||Present Value = $5 / (1 + (0.1/2))^3 = 4.3|
|Period 4||$5||Present Value = $5 / (1 + (0.1/2))^4 = 4.1|
|Period 5||$5||Present Value = $5 / (1 + (0.1/2))^5 = 3.9|
|Period 6||$5||Present Value = $5 / (1 + (0.1/2))^6 = 3.7|
|Period 7||$5||Present Value = $5 / (1 + (0.1/2))^7 = 3.5|
|Period 8||$5 + $100||Present Value = $105 / (1 + (0.1/2))^8 = 71|
In order to calculate the price of the bond, all the respective present values of payment schedules are subsequently added. Therefore, the total price of the bond would be $ 99.8.
Difference between Amortized Bond and Bullet Bond
Amortized Bonds and Bullet Bonds mainly vary on the grounds of payoffs. In the case of amortized payoffs, the principal payment is extended with the interest payments on a periodic basis.
On the other hand, in bullet bonds, periodic payments only comprise interest payments, whereas the principal amount is extended at the end of the bond maturity.
The difference between amortized bond and bullet bond is further depicted in the following diagram:
Advantages and Disadvantages of Bullet Bonds
There are numerous different advantages and disadvantages from the perspective of the issuer and the receiver pertaining to bullet bonds. The advantages of bullet bonds are as follows:
- The greatest upside of bullet bonds is the fact that it has a stabilized interest rate. In the case where interest rates are rising, this tends to be an extremely resourceful tool.
- In the same manner from the perspective of the issuer, only interest payments have to be issued during the course of the bond. The balloon payment is due at the end of maturity. Therefore, payouts are lesser in the forthcoming years from when the bond is issued.
- There is no inherent reinvestment risk on the principal proportion for the investor in the given case.
However, there are also a few downsides from the perspective of the issuer when it comes to bullet bonds. They are as follows:
- From the perspective of the issuer, bullet bonds have a higher interest rate. From the perspective of the bullet bond issuer, there is a need to manage an additional cost of asset and liability management.
- There is a significant counterparty risk that needs to be managed. For example, banks that invest in bullet bonds need to ensure that they make additional capital provisions for the given bonds.
- There is no option for the user to call back the bond. Hence, there is a lesser degree of flexibility when it comes to bullet bonds.
- The coupon rate on bullet bonds is considerably lower than amortized bonds. Therefore, the investors tend to be at a disadvantage in the case where the interest rate increases.