Amortising Bond

An amortising bond is a bond that repays its principal gradually, through scheduled instalments paid alongside interest, so that little or nothing is left to repay on the final date. Each payment reduces the amount outstanding, and later interest payments are calculated on the smaller balance. Issuers use the structure when the asset being financed produces steady cash over time, such as a toll road, a power plant, an aircraft or a pool of mortgages.

The opposite structure is the bullet bond, which pays interest only and returns all principal at maturity. Most government and corporate bonds are bullets. Amortising structures are common in project and infrastructure finance, municipal borrowing, some emerging-market sovereign bonds and almost all securitisations, including the mortgage-backed security (MBS) and the asset-backed security (ABS).

The terms of the bond set out a redemption schedule giving the amount or percentage of principal due on each date. The main patterns are:

• Level payment. Each instalment is the same total amount, with interest forming a larger share at first and principal a larger share later, as in an amortising loan.
• Equal principal. The same amount of principal is repaid each period, so total payments decline as interest falls.
• Sculpted. Repayments are shaped to match the forecast cash flow of a project, often with a grace period before principal starts.
• Pass-through. Principal is repaid as and when the underlying loans repay, so the schedule is an estimate, not a commitment.

A bond may also be partly amortising, with instalments that repay only some of the principal and a larger final "balloon" payment. This is different from a sinking fund, under which the issuer retires a portion of an issue each year by buying bonds in the market or drawing them by lot; there, individual holders are either repaid in full or not at all, whereas amortisation repays every holder pro rata.

Operationally, each instalment is a partial bond redemption applied equally to all holders. The paying agent distributes principal and interest together through the central securities depository on each payment date.

Two conventions are used to show the reduced balance. In one, the nominal amount of each holding is reduced. In the other, the nominal amount stays the same and a pool factor is published: a number between one and zero showing the share of original principal still outstanding. A holding of 1,000,000 nominal with a factor of 0.75 has 750,000 outstanding. Interest, accrued interest and settlement amounts are all calculated on the outstanding balance, so using the wrong factor is a frequent source of settlement and reconciliation errors.

Because principal is returned early, the stated maturity overstates how long an investor's money is at work. Investors therefore use the weighted average life, which is the average time until each unit of principal is repaid, weighted by the amount repaid. An amortising bond with a ten-year final maturity might have an average life of five or six years, and it is usually priced against a benchmark of that shorter maturity.

The yield to maturity is calculated in the usual way, by finding the rate that discounts all payments of interest and principal to the price, but the cash flows include principal on many dates. An amortising bond has a shorter duration than a bullet with the same coupon and final maturity, so its price is less sensitive to changes in interest rates.

Where repayments depend on borrower behaviour, as in mortgage securities, the investor also faces prepayment risk: principal tends to arrive faster when rates fall and slower when they rise, in both cases to the investor's disadvantage.

For the issuer, amortisation avoids the refinancing risk of a large single repayment and matches debt service to income. For investors, credit exposure falls over time, which can support a higher rating for long-dated project debt.

The drawbacks are reinvestment risk and complexity. The investor receives principal in small amounts that have to be reinvested at whatever rates then apply. Holdings need more administration than bullets, since balances change on every coupon payment date, and smaller outstanding amounts can make the bond less liquid late in its life. The final instalment is handled like any other bond redemption.