What Is a Bullet Bond?
Let me explain what a bullet bond is. It's a debt investment where the entire principal value gets paid back in one lump sum on the maturity date, instead of being amortized over time. These bonds are non-callable, so the issuer can't redeem them early.
If you're looking at bullet bonds from stable governments, they usually come with a low interest rate because the risk of default on that big payment is minimal. On the other hand, a corporate bullet bond might need to offer higher interest if the company's credit rating isn't top-notch.
Overall, bullet bonds pay less than similar callable bonds since they don't allow the issuer to buy them back if interest rates drop.
Key Takeaways
Here's what you need to remember: A bullet bond is a non-callable bond where the principal comes back as a lump sum at maturity. Governments and corporations issue them in various maturities. The issuer takes on the risk that interest rates might fall during the bond's life, making its return rate look expensive in comparison.
Understanding Bullet Bonds
Both corporations and governments put out bullet bonds with maturities ranging from short to long term. If you build a portfolio of these, it's called a bullet portfolio.
For the issuer, a bullet bond is riskier than an amortizing bond because it means repaying everything on one date, not in smaller chunks over time.
That's why new market entrants or those with shaky credit ratings might find more takers with amortizing bonds instead of bullet ones.
As an investor, you'll typically pay more for a bullet bond than an equivalent callable one, since you're shielded from a call if rates decline.
Tip
Just so you know, a 'bullet' refers to a one-time lump-sum repayment of an outstanding loan by the borrower.
Bullet Bonds vs. Amortizing Bonds
Bullet bonds and amortizing bonds differ mainly in how payments work.
With amortizing bonds, you get regular payments that cover both interest and part of the principal, so the whole loan is paid off by maturity.
Bullet bonds, however, might only require small interest-only payments or none at all until maturity, when you have to repay the entire loan plus any leftover interest.
Example of a Bullet Bond
Pricing a bullet bond is straightforward. You calculate the total payments for each period and discount them to present value using this formula: Present Value (PV) = Pmt / (1 + (r / 2)) ^ (p), where Pmt is the total payment for the period, r is the bond yield, and p is the payment period.
Take a bond with a par value of $1,000, yield of 5%, coupon rate of 3%, paying coupons twice a year over five years. That means nine periods of $15 coupon payments, and the tenth period includes a $15 coupon plus the $1,000 principal, totaling $1,015.
Present Value Calculations
- Period 1: PV = $15 / (1 + (5% / 2)) ^ (1) = $14.63
- Period 2: PV = $15 / (1 + (5% / 2)) ^ (2) = $14.28
- Period 3: PV = $15 / (1 + (5% / 2)) ^ (3) = $13.93
- Period 4: PV = $15 / (1 + (5% / 2)) ^ (4) = $13.59
- Period 5: PV = $15 / (1 + (5% / 2)) ^ (5) = $13.26
- Period 6: PV = $15 / (1 + (5% / 2)) ^ (6) = $12.93
- Period 7: PV = $15 / (1 + (5% / 2)) ^ (7) = $12.62
- Period 8: PV = $15 / (1 + (5% / 2)) ^ (8) = $12.31
- Period 9: PV = $15 / (1 + (5% / 2)) ^ (9) = $12.01
- Period 10: PV = $1,015 / (1 + (5% / 2)) ^ (10) = $792.92
Final Bond Price
Adding up these 10 present values gives you $912.48, which is the bond's price.
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