Serial Bond

Serial bonds, unlike bullet or term bonds that repay the entire principal at the time of maturity, repay it in installments at regular intervals, i.e., the entire issue consists of multiple securities or CUSIP of varying maturities and each such CUSIP or a bunch of CUSIP number matures at a different time according to a repayment schedule specified in the bond indenture.

Generally, serial bond issue is made by the center, state governments, or municipalities to finance large public works projects, such as highways, toll roads, flyovers, schools, etc. The projects require huge investment in the initial phase, and after these projects start generating revenues, a consistent and regular stream of cash flow is expected. These revenues are used to pay off the debt. Therefore, they are sometimes also known as revenue bonds.

Serial bonds are a financial instrument characterized by a series of bonds with different maturity dates, typically issued by municipalities, corporations, or governments. These bonds are structured to mature at regular intervals, spreading the repayment of the principal amount over several years.

One notable aspect of serial bonds is their staggered maturity dates, allowing issuers to manage their debt repayment more systematically and sustainably. Each bond within the series represents a portion of the total debt, and as each bond matures, a portion of the principal is repaid. This gradual repayment schedule contrasts with other bond structures, such as term bonds, which have a single maturity date for the entire principal amount.

Investors are attracted to the serial bonds structure for their predictable cash flow, as the periodic maturation of bonds provides a steady stream of principal repayment. Additionally, the staggered maturity dates can align with the issuer's expected cash inflows or revenue generation, providing a more manageable repayment structure.

The flexibility of serial bonds allows issuers to match debt service payments with specific projects or capital expenditures. For example, if a municipality undertakes a series of infrastructure projects with varying completion timelines, serial bonds enable them to align debt repayment with the benefits derived from each project.

It is important to note that serial bonds may carry different interest rates for each maturity date, reflecting prevailing market conditions at the time of issuance. This variable interest rate feature allows issuers to adapt to changes in interest rate environments over the life of the bond series.

Therefore, serial bonds offer issuers a strategic and flexible approach to debt management, allowing for a systematic repayment of principal and aligning debt service with specific project timelines. Investors, in turn, are attracted to the steady cash flow provided by the regular maturation of bonds within the series.

Investors choose between different types of serial bond issues that match their financial objectives. Let us understand them through the detailed discussion below.

• Level-Principal Serial Bonds: In this type, each bond within the series has an equal principal amount. Issuers opt for level-principal serial bonds when seeking a consistent and predictable principal repayment schedule.
• Increasing-Principal Serial Bonds: Also known as balloon serial bonds, these involve increasing principal amounts for each bond in the series. This structure allows for lower debt service payments in the initial years, gradually increasing as subsequent bonds mature.
• Declining-Principal Serial Bonds: With this type, the principal amount decreases with each bond's maturity. Issuers may choose declining principal serial bonds to front-load debt service payments, managing higher repayment amounts in the earlier years.
• Term Structure Variations: Serial bonds can be structured with various term lengths, aligning with the issuer's financial strategy and the timeline of specific projects or expenditures. The flexibility in term structure is a key feature, allowing issuers to tailor the bond series to their unique financial needs.
• Fixed or Variable Interest Rates: Serial bonds may carry fixed or variable interest rates, providing issuers with options to navigate different market conditions. The choice between fixed and variable rates depends on prevailing interest rate environments and the issuer's risk tolerance.

Now that we understand the basics, types, and other related factors relating to serial bond structure, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

Let us suppose that the issuer issues serial bonds worth $10 million on 1st January 2010 at 10% annual interest payable on December 31st every year. The issuer also specifies the following repayment schedule:

The following inferences can be made from the table above:

• Till December 31st, 2014 entire $10 million is due to the annual interest is $1 million
• Till December 31st, 2015, the entire $10 million is due to the annual interest of $1 million. However, on this date, $2 million is redeemed, leaving the balance of $8 million for the years to come
• On each subsequent December 31st, $2 million is redeemed, reducing the balance by $2 million for the years to come and thereby reducing the interest expense accordingly

Example #2

As mentioned earlier, Municipalities are one of the issuers of serial bonds and are governed by the Municipal Securities Rulemaking Board (MSRB) in the US. They have an electronic database of the bonds issued by them, which contains all the information on their serial bond issues as well. This database is called Electronic Municipal Market Access (EMMA).

Serial bond issues can be accessed on this website:  emma.msrb.org.

This website also contains detailed official statements released by the issuers on several such issues, which give information such as the repayment schedule, taxability of the issue, present financial position of the issuer, companies, or institutions that are liable to pay off the issues, etc. Following is one such issue:

County of Ulster, New York Public Improvement (Serial) Bonds

• In this issue, general obligation serial bonds worth $5,280,000 were issued as per their official statement dated August 1st, 2019, for improvements of public real estate.
• These will become due for redemption on November 15, 2019-2027, and are not subject to redemption prior to maturity, i.e., any date before and the principal redemption schedule is as follows:

Source: County of Ulster, New York Public Improvement (Serial) Bonds: official statement dated August 1st, 2019

• The securities under this issue are of denominations of $5000 each.
• A purchase will be made on the book-entry system only, i.e., there will be no physical transfer of bond, only transfer entries will be made in the books of Depository Trust Company (DTC) and direct/indirect participants.
• The county will generate revenues by levying taxes on real estate within the procedures, limitations, and formula set forth by the “Tax levy limitation law.”
• The revenue generated is transferred down the chain through DTC for payment of interest and principal.
• Following is the flow of securities and cash flow.

• The County spreads the word that the bonds are being issued, and this is trickled down to bondholders via a chain of DTC who, in turn, inform the direct/indirect participants.
• Prospective bondholders approach their nearest participant and express their interest in purchase and deposit funds for the same.
• Participants convey the word up the chain.
• The county is responsible for delivering the securities down the chain.
• The same chain is followed for interest and principal payments.
• This flow is maintained to achieve deeper penetration of securities.

The advantages of investing in a serial bond issue are as follows:

• Lowers default risk: As the principal is repaid in installments at regular intervals, not the entire amount becomes due on one single date, and therefore it reduces the instances of default with each such repayment by reducing the impact of unforeseen future events which might lead to unavailability of large sum on the single maturity date.
• Attracts more investors: Investors with different time horizons can invest in these bonds depending upon their investment needs. Therefore these bonds are lucrative for a wider pool of investors. Further, interest rates also vary. Shorter maturity bonds have lower interest rates, while longer ones have higher interest rates to compensate the investor for undertaking higher risk.
• Reduced cost of debt: Issuers prefer these as they reduce interest liability with each principal repayment date. This leads to a lower weighted average interest cost in comparison with a bullet bond.

Despite the various advantages, there are a few factors of concern that bother investors and regulators alike. Let us discuss the disadvantages of the serial bond structure through the points below.

• Reinvestment risk: Although these reduce the default risk for the investors, they create reinvestment risk if the interest rate environment is declining. Investors may need to make use of derivative contracts such as forward rate agreements, or swaps or options to hedge against such fluctuation in the interest rates, which is an additional cost, or may bear the reinvestment risk.
• Inappropriate for some projects:  These should be issued only for the projects which generate consistent and regular cash inflows to pay off the principal installments, and if such projects face a certain setback, they lead to piling up of obligations very early in the project.

Let us understand the differences between serial bond issues and term bonds through the comparison below.

Serial Bonds

• Series consists of bonds with different maturity dates.
• Principal amount repaid gradually as each bond matures.
• Provides a systematic and staggered approach to debt service.
• Ideal for projects with diverse completion timelines.
• Offers predictable cash flow with periodic principal repayments.
• They may have different interest rates for each maturity date.

Term Bonds

• Features a single maturity date for the entire principal amount.
• Results in a lump-sum repayment at the end of the term.
• Provides simplicity with a fixed maturity date.
• Suited for projects with a uniform timeline or singular funding requirement.
• Attracts investors seeking a singular repayment event.
• Generally, it maintains a consistent interest rate throughout the term.