Amortized Bond

Amortized bonds are a type of debt instrument where the principal is repaid gradually over the bond’s life through periodic payments that include both interest and principal. Unlike traditional bonds that repay the entire principal at maturity, amortized bonds reduce the outstanding principal with each payment. This results in lower interest payments over time since the principal decreases with each installment. Amortized bonds are commonly used in mortgage-backed securities or certain corporate bonds, providing bondholders with a steady cash flow and reducing risk, as the issuer progressively lowers their debt obligation throughout the bond’s term.

Key Features of Amortized Bonds:

1. Regular Payments:

The bondholder receives periodic payments that consist of both interest and a portion of the principal. This is similar to how mortgage payments work, where each payment reduces the outstanding loan amount while also covering the interest.

2. Gradual Principal Reduction:

With each payment, the bond’s outstanding principal decreases, which in turn reduces the amount of interest due on future payments.

3. Fixed Payment Structure:

Typically, amortized bonds have a fixed schedule of payments that ensures the entire bond principal is paid off by the bond’s maturity date.

4. Common Example:

Mortgage-backed securities (MBS) are often amortized bonds. They are backed by pools of mortgages, which are structured in a way that both interest and principal are repaid over time.

How Amortized Bonds Work:

When an entity issues an amortized bond, the bondholder receives a series of equal payments over the bond’s life, including both interest and principal. For example, suppose a bond issuer sells an amortized bond worth ₹1,00,000 with a 5% interest rate over a 5-year period. Each year, the issuer makes a fixed payment, which covers the interest for that year and a portion of the principal.

Example

Here’s an example of how an amortized bond works:

Bond Details:

• Face Value (Principal): ₹1,00,000
• Annual Interest Rate: 5%
• Bond Term: 5 years
• Payment Frequency: Annual (once a year)

In this case, the bondholder receives an equal annual payment that includes both interest and principal repayment. By the end of the bond’s term, the entire ₹1,00,000 principal will be paid off.

Step-by-Step Amortization Calculation:

Each year, the bond issuer makes a fixed total payment, and part of that payment covers the interest on the remaining principal, while the rest goes toward reducing the principal. The interest is calculated on the outstanding principal, which decreases each year.

Using an amortization schedule, we can calculate the equal annual payment amount.

The formula for calculating the fixed annual payment is:

Annual Payment=P × r/1−(1+r)⁻ⁿ

Where:

• P is the principal amount (₹1,00,000)
• r is the annual interest rate (5% or 0.05)
• n is the number of years (5 years)

Annual Payment=1,00,000×0.05/ 1−(1+0.05)⁻⁵

                                                           =₹23,097.72

So, the bondholder will receive ₹23,097.72 annually.

Amortization Schedule:

Explanation:

• Year 1: The bondholder receives ₹23,097.72. Of this, ₹5,000 is interest (5% of ₹1,00,000), and ₹18,097.72 goes toward repaying the principal. The remaining principal after Year 1 is ₹81,902.28.
• Year 2: The next payment is ₹23,097.72, but the interest is lower (₹4,095.11) because it’s calculated on the reduced principal of ₹81,902.28. The remaining principal continues to decrease with each payment.
• By Year 5, the entire principal is repaid, and the bondholder receives their last payment.

Summary:

In this example, the bondholder receives ₹23,097.72 annually over 5 years, with part of each payment covering interest and part going toward reducing the outstanding principal. This gradual repayment structure is typical for amortized bonds.