When a loan is repaid, the instalments have the interest component first and the principal amount is paid when the loan matures. As opposed to this, amortization is when the instalments contain both the interest component as well as the principal amount. It is also used to expense the cost of an intangible asset over its lifespan.
What is Amortization?
Amortization is a planned process wherein an outstanding loan balance drops over time through monthly payments made by the borrower. The debt is separated into instalments which are to be paid over time.
The process of amortization comes into the picture in mainly two scenarios.
- First is when the debt is paid off by regular payments of both the principal amount and interest over time. An amortization schedule is used to keep a track of both the interest component and principal component of each instalment paid.
- The second scenario is related to intangible assets wherein amortization is used to expense the cost of an intangible asset over its life period.
Amortization reduces the book value of a loan or an intangible asset across a set period and is an efficient process of measuring the consumption and value of an intangible asset.
With the borrower making the monthly payments, the outstanding loan balance drops over time through amortization.
What is an Amortized Bond?
The key to understanding amortized bonds lies in understanding the repayment structure. When a bond is amortized, one portion of the instalment (repayment) will go towards interest and the other portion towards the principal.
Amortized bonds are where the entire face value is received along with the interest as regular payments. This is synonymous with paying EMIs on a loan. The amortization schedules define the amount of interest payment, discount, or premium for every instalment. The initial period usually involves a higher proportion of interest payments. This is because at this stage the entire principal payment is outstanding. Over a period, as the outstanding principal decreases, the proportion of interest in the payments reduces.
A fixed-rate residential mortgage is a common example. This is because the monthly payment remains constant over its life. However, each payment represents a slightly different percentage mix of interest versus principal.
The interest portion of the loan will be higher in the early years than the principal part. The tables turn as the loan matures, and the principal portion is higher and the part of each payment that goes towards interest will be lesser. An amortization schedule or an amortization table is the appropriate tool for computing the interest and principal component in every bond payment.
How do Amortized Bonds Work?
Company Y issues a bond that is amortized, for Rs. 18,000. This is for a period of 10 years with a coupon rate of 10%. The interest will be Rs. 1800. Taking into consideration the fact that the payments will be made on an annual basis, the fixed instalment will be 19,800/10 = Rs. 1,980. Therefore, in the annual debt service, the principal amount will be Rs. 1,800 and Rs. 180 will be the interest component.
Technically, the amount of instalment remains the same but the principal and interest components vary every year.
To understand the types of Amortized Bond Premium Calculation, it is first important to know the concept of amortized bond premium.
An amortizable bond premium is an excess price paid for a bond, which is way more than its face value. It can be tax deductible at a specified rate over the life of the bond. There are many benefits to this and the one that stands out is that it reduces the investor’s taxable income.
Following are the methods used for Amortized Bond Premium Calculation:
1. Straight Line Method
The first is Straight-line bond discount or bond premium. In this method, the amortization amount remains the same. Taking the coupon rate into consideration, if the said rate is lower than the interest rate, the bond will be issued at a discount at par value. And, the higher the coupon rate, the bond issued will be at a premium to its par value.
‘Par value is another term for the bond’s face value or the stated value of the bond at the time of issuance.’
This also implies that when the market interest rate and the coupon rate are equal, the issue price and face value will also fall in the same line.
2. Effective Interest Rate Method
The second method of calculating Amortized Bond Premium is the Actual or Effective Interest Rate Method. The effective interest rate method demystifies the connection between an asset’s book value and the interest. It is used to amortize the premium to the interest expense over the bond’s lifespan.
Benefits of Investing in Amortized Bonds?
Apart from being a planned and systematic process, there are many benefits to investing in amortized bonds.
- Steady Cash Flow: As the interest and principal components, both are a part of the instalments paid, amortization reduces the possibility of you losing your principal amount in case of any default. A part of the principal amount is paid over time. This also ensures a steady cash flow for the investors.
- Reduces the Risk Factor: Amortization also protects investors against fluctuating interest rates. As most of the interest is paid during the early years, the interest risk later is much lesser.
- A Safer Alternative: The bond ratings help investors choose the right mutual fund to invest in. Thus, investing in high-rated bond funds can be less risky than bonds with lower ratings.
Disadvantages of Amortized Bonds
The biggest disadvantage of amortized bonds is lower yield. Lower yield is due to reduced coupon payments upon partial face value redemption.
Things to Consider Before Investing in Amortized Bond
Amortization can prove to be very efficient. But only in the right situation. It is important to take into consideration a few things before investing in amortized bonds.
- Tax Situation: As amortization majorly affects the tax you pay, it is very essential to think clearly about how it will affect your tax situation.
- Managing the Amortized Money: Second, one has to think in advance about how the money for amortization will be managed. It is important to have an investment plan in place to put the money from amortized bonds to better use.