What is Bullet Bond?

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:

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:-

Advantages

  • One of the foremost advantages to the issuer is that it freezes the interest rate and is 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.

This has been a guide to what is a bullet bond and its definition. Here we discuss an example, strategy, and differences of bullet bond with amortizing bond along with advantages and disadvantages. You can learn more about financing from the following articles –

  • Bottom FishingYankee BondsGuaranteed Bonds MeaningHigh Yield Bonds