What are Amortized Bonds?

Last Updated on September 18, 2023 by BFSLTeam BFSLTeam

An amortized bond is a type of bond where the principal amount of the bond is gradually paid off over the life of the bond. This means that instead of paying back the entire principal amount of the bond at maturity, the borrower makes periodic payments that include both interest and a portion of the principal.

What are Face Values?

The face value of a bond is the amount that the bond is worth when it is issued. This is the amount that the borrower promises to pay back to the lender at maturity, and it is also the amount that is used to calculate the interest payments on the bond.

How Amortized Bond Works?

Amortized bonds are a type of fixed-income security that are designed to pay off the principal amount of the bond in instalments over the life of the bond, rather than in a single lump sum payment at maturity. The process of paying off the principal amount over time is known as amortization.

When an investor buys an amortized bond, they receive a series of regular interest payments, as well as a portion of the principal amount each time a payment is made. Each interest payment includes both an interest component and a principal component. Over time, the principal component of each payment increases while the interest component decreases, until the full principal amount of the bond has been paid off.

The amount of each payment and the schedule for the payments is determined at the time the bond is issued, and is based on the interest rate, the term of the bond, and the amount of the principal.

Methods of Bond Amortization

There are several methods of amortization that can be used for amortized bonds. The most common methods include:

• Straight-line amortization: This method involves dividing the face value of the bond by the number of payments to be made and using this amount to calculate the portion of the principal to be repaid in each payment.
• Effective interest rate amortization: This method involves using a predetermined interest rate to calculate the interest and principal portions of each payment, with the interest portion decreasing over time as the principal portion increases.

These methods also facilitate a bondholder to have a fair idea about the interest amount amortization. Interest amount amortization is an important concept in finance, as it allows borrowers and investors to understand how much they will be paying in interest over the life of the loan or bond, and to plan accordingly. It also helps to ensure that the borrower or investor is paying a fair and consistent amount of interest over time.

Example of Bond Amortization

Let’s look at an example of a 5-year bond with a face value of Rs 1,000 and an annual interest rate of 5%. The bond is amortized using the straight-line method, with equal principal payments made each year.

Year 1: Payment = Rs 215.89, Interest = Rs 50, Principal = Rs 165.89
Year 2: Payment = Rs 215.89, Interest = Rs 41.29, Principal = Rs 174.60
Year 3: Payment = Rs 215.89, Interest = Rs 31.38, Principal = Rs 184.51
Year 4: Payment = Rs 215.89, Interest = Rs 21.23, Principal = Rs 194.66
Year 5: Payment = Rs 215.89, Interest = Rs 10.79, Principal = Rs 205.10

At the end of the 5-year period, the entire principal amount of Rs 1,000 has been repaid, along with a total of Rs 159.69 in interest.

Benefits of Amortized Bonds

Amortized bonds have several benefits for both borrowers and lenders

There are several benefits of investing in amortized bonds, including:

• Predictable cash flow: Amortized bonds can provide investors with a predictable stream of cash flow over the life of the bond. This can be beneficial for investors who are looking for a steady source of income.
• Lower risk: Amortized bonds are considered to be lower risk than other types of bonds, such as zero-coupon bonds, because they pay back the principal amount over time. This can help to reduce the risk of default, as the issuer is making regular payments toward the principal.
• Diversification: Investing in a portfolio of amortized bonds can help to diversify an investor’s portfolio, spreading out risk across multiple issuers and maturities.
• Price stability: Because the principal amount is paid back gradually over time, the price of an amortized bond is generally more stable than other types of bonds that pay back the principal in a single lump sum at maturity.
• Flexibility: Amortized bonds can be structured to meet the needs of both issuers and investors, with a variety of payment schedules and interest rates available.

Overall, amortized bonds can be a valuable addition to an investor’s portfolio, providing a steady stream of income, lower risk, and diversification benefits. However, as with any investment, it’s important to carefully consider the risks and benefits before making an investment decision.

Final thought

In conclusion, an amortized bond is a type of bond where the issuer repays the principal amount of the bond over its life through a series of periodic payments that include both interest and principal. This payment structure allows investors to receive a steady stream of income and reduces the issuer’s risk by spreading out the repayment of the principal over time.