What is Bullet Bond?
Bullet Bonds (also known as Straight Bonds) are standard bonds that make periodic interest payments and repayment of the principal amount at maturity of the bond and don’t contain any exotic features such as embedded call feature or put feature etc. These bonds aren’t principal amortized and their principal amount remains the same throughout the tenure and payable only at the end of the tenure.
These bonds are popularly issued by sovereign governments to fund their expenditure and attract a lot of demand from the investor community as such bonds pay periodic interest payments and usually carries virtually no risk as the probability of failure of the government of a country is remotely low. Bullet bonds issued by other than the government carry higher interest payments due to the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more associated with any other issuer other than the government.
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Example of Bullet Bonds
The US government decided to issue a dollar-denominated bullet bond that carries a fixed coupon interest payment of 3.5% payable semi-annually maturing after 5 years with a principal face value of $1000 on 1st January 2018. The bonds mature on 31st Dec 2022. The current yieldCurrent YieldThe current yield formula essentially calculates the yield on a bond based on the market price instead of face value. The current yield of bond= Annual coupon payment/current market priceread more on such bonds is 3%.
The above bonds will make payment after every six months equivalent to $35 and will repay the principal amount of $1000 along with the last interest payment on 31st Dec 2022. Based on the facts, we can determine the present value of such a bullet bond, as shown below:
| Particulars | Value |
|---|---|
| Face Value | $1,000 |
| Coupon Rate | 3.50% |
| Coupon Amount | $35.00 |
| Coupon Frequency | Semi Annually |
| No of Coupon Payments | 10 |
| Maturity in Years | 5 |
| Date of Issue | 01.01.2018 |
| Date of Maturity | 31.12.2022 |
| Current Yield | 3.00% |
Solution:
Determine the present value of such a bond, as shown below:
Alternatively, the same can be calculated by discounting the Coupon payments and Principal paymentPrincipal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more individually, as shown below:
Strategy for Bullet Bonds
- The reason behind investing or issuing this vary and mostly is based on the interest rate view that the two sides have, i.e., Investor and the Issuer. Apart from the many benefits that are shared in advantages below, the major deciding factor for an investor to go for a bullet bond is when the interest rate cycle is at its peak and expected to fall thereafter, in such case investing in a bullet bond will lock in the principal at such rates and when yield starts falling the value of such investments will swell up for such investors.
- Similarly, when the interest rate cycle is at rock bottom and is expected to reverse thereafter, it starts rising; in such a case, issuing bullet bond will be beneficial for the issuer as when yields will start rising, the coupon required by the investors will also rise, and the issuer will be better off locking in at lower coupons before the interest rate cycle starts ticking up.
Head to Head Differences
Here are the key differences between:-
| Basis for comparison | Bullet Bond | Amortizing Bond |
|---|---|---|
| Meaning | It involves periodic payment of Interest only and lump sum payment of principal at the maturity of the Bond. | Amortizing Bond involves payment of both Interest and Principal during the tenure of the bond on each coupon payment date. |
| Interest Expense | It is constant through the tenure as only interest payment is made, and the principal portion is paid only at the end. | It varies during the tenure of the bond as during initial years interest portion will be higher and in later year principal portion. |
| Counterparty risk | Counterparty risk is very high in the case of Bullet Bonds as a majority portion of the Bond payment (Principal) is made at the end of the Bond tenure. | Counterparty Risk is comparatively less compared to Bullet Bond as a certain portion of the principal is paid with each payment. |
| Exotic option | They are normally non-callable by Issuer. | Amortizing Bonds can be callableBonds Can Be CallableA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls.read more by the Issuer. |
| Interest rate Risk | It carries a high level of Interest Rate risk for the Issuer. | It carries less Interest Rate Risk as the Bonds can be redeemed early based on the Interest rate scenario. |
| Coupon | Normally carries less coupon rate compared to Amortizing Bonds. | Normally carries a comparatively high coupon rate than Bullet ceteris paribus. |
Advantages
- One of the foremost advantages to the issuer is that it freezes the interest rate and beneficial to the issuer in cases where interest rates are upward rising.
- Another advantage to the issuer is the outflow of only interest payment during the tenure instead of regular interest plus principal outflow in case of amortizing bonds.
- There is no reinvestment riskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity.read more on the principal portion for the investor in this case.
Disadvantages
- It carries a high amount of Interest Rate RiskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more for the Issuer, which needs to be managed by the Issuer, adding to the additional cost of Asset Liability Management.
- It carries a high amount of Counterparty risk, and as such, Banks who invest in such Bullet Bonds need to make additional capital provision for such bonds compared to Amortized Bonds.
- Another disadvantage is the lack of exotic features (Callable or Puttable), which leads to less flexibility.
- They carry low coupon rates compared to an Amortized Bond, and as such, Investors of such bonds are at a disadvantage in case of rising interest rate scenarios.
Conclusion
Bullet Bonds are the most common and widely issued bonds across the globe. Banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more regularly invest in such bonds issued by a sovereign government, and it forms a major part of their investment portfolio. It is also important to mention that non-sovereign bonds carry a high amount of counterparty risk, which needs to be taken into account before investing.
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