Tuesday 28 August 2018 by Asmita Kulkarni Education (basics)

Understanding amortising bonds

Amortising bonds are securities that return principal to investors throughout the life of the bonds. Director of Investment Strategy Group, Asmita Kulkarni, provides an explanation of how these bonds work.

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Amortising bonds return principal to bondholders throughout the life of the security. Although investors may not like the higher cashflow that comes with capital repayment, amortisation reduces the bond’s inherent risk as the principal outstanding at maturity is reduced. This feature can be a welcome addition when investing in high yield bonds.

Background

Being an over the counter market allows bond issuers to offer securities with various features. This means that unlike the stock market, there is no such thing as a ‘common bond’. Bonds can have: fixed or floating rate coupons, a fixed maturity date or options for early redemption, a bullet principal repayment or the ability to amortise over the life of the bond. We will explore amortisation further in this note.

A bullet bond is a security where all principal is repaid in full at maturity. This means the cashflows received during the life of a bullet bond comprise of only the interest component known as coupons. Consequently, the bond factor, being the proportion of the original face value outstanding, of a bullet bond remains at 1.0 (or 100%) until the maturity of the bond.

Amortising bonds, on the other hand, return principal to bondholders throughout the life of the bond. This means, cashflows from amortising bonds comprise of both principal and interest and the bond factor of these bonds at maturity is less than 1.0. Interest paid on amortising bonds is based on the outstanding balance of principal at the time of the coupon payment. Therefore, the amount of interest received reduces as the outstanding balance of principal reduces. Amortisation can be either scheduled or unscheduled.

Under a scheduled amortisation structure principal is returned to investors at a predetermined rate. This is the case for bonds issued by Impact, Plenary, Merredin, Lucas, NextGen and Zenith, among others. For example, the Impact bond repays $1m of principal each quarter reducing the outstanding principal from $45m at issuance to $25m by maturity in February 2021. This means that for a $100,000 investment, each quarterly cashflow includes $2,222 of principal along with interest.

Bonds such as Residential Mortgage Backed Securities (RMBS) typically have an uncertain repayment profile as the underlying mortgage repayments are not fully known ahead of time. Mortgage holders repay their P&I loans (principal and interest, i.e. not interest only), either at the minimum principal requirement, or at higher than required repayments through scheduling a specific amount to direct debit or by refinancing their loans. Generally speaking, prime or bank quality mortgages repay principal at a rate of 20%pa ahead of schedule and non-conforming mortgages, borrowers with an impaired credit history, repay additional principal at a rate of about 35%pa.

Indexed annuity bonds (IABs) also fall under the category of amortising securities. These bonds repay principal and interest until maturity. The principal repayment schedule is calculated in essentially the same way as a conventional home mortgage. In the absence of inflation, each payment would be equal, consisting of part principal and part interest, just like a mortgage. This amount is also referred to as the base payment or ‘base annuity’. The base payments are indexed by inflation, over the life of the asset, resulting in an inflation protected payment over the life of the bond.

What amortisation means for issuers

  • Lower refinancing task at maturity as the outstanding balance is lower than at issuance.
  • Decreasing funding cost as interest has to be paid on a lower principal balance.
  • In the case of RMBS, principal received is paid to investors so the issuer has less investment risk associated with investing the proceeds until maturity.
  • However, in the case of corporate issuers, amortisation can also mean using cash that can be deployed elsewhere.

What amortisation means for investors

  • Amortising securities naturally de risk over time as they repay principal.
  • Investors have lower reinvestment risk at maturity when proceeds have to be invested.
  • Interest received on amortising bonds decreases as the outstanding principal amount amortises.

Amortising bonds on offer


Conclusion

Bonds that amortise add comfort for investors owning sub investment grade securities given the amortisation reduces the inherent risk in a bond as the amount of principal outstanding at maturity is reduced. There is a wide range of amortising bonds on offer including corporate issuance, RMBS and IABs.

To find out which amortising bonds make the recommended list, please click here for the full report.

Please speak to your Relationship Manager to discuss these or any other investment opportunities or contact the Investment Strategy Group at ISG@fiig.com.au.

 

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