What Is an Amortized Bond?

An amortized bond is one in which the principal (face value) on the debt is paid down regularly, along with its interest expense over the life of the bond. A fixed-rate residential mortgage is one common example because the monthly payment remains constant over its life of, say, 30 years. However, each payment represents a slightly different percentage mix of interest versus principal. An amortized bond is different from a balloon or bullet loan, where there is a large portion 🐈of the principal that must be repaid only at its 🥀maturity.

Understanding Amortized Bonds

The principal paid off over the life of an amortized loan or bond is divvied up according to an 澳洲幸运5开奖号码历史查询:amortization schedule, typically through calculating equal payments all along the way. This means that in the early years of a loan, the interest portion of the debt service will be larger than the principal portion. As the loan matures, however, the portion of each payment that goes towards interest will become lesser and the payment to principal will be larger. The calculations for an amortizing loan are similar to that of an annuity using the 澳洲幸运5开奖号码历史查询:time value of money, and can be carried out quickly using an 澳洲幸运5开奖号码历史查询:amortization calculator.

Amortization of debt affects two fundamental risks of bond investing. First, it greatly reduces the 澳洲幸运5开奖号码历史查询:credit risk of the loan or bond because the principal of the loan is repaid over time, rather than all at once upon maturity, when the risk of default is the greatest. Second, amortization reduces the duration of the bond, lowering the debt's sensitivity to 澳洲幸运5开奖号码历史查询:interest rate risk, as compared with other non-amortized debt with the same maturity and coupon rate. This is because as time passes, there are smaller interest payments, so the 澳洲幸运5开奖号码历史查询:weighted-average maturity (WAM) of the🌃 cash flows associated with the bond is lower.

Example of Amortizing a Bond

30-year fixed-rate mortgages are amortized so that each monthly payment goes towards interest and principal. Say you purchase a home with a $400,000 30-year fixed-rate mortgage with a 5% 🍌interest rate. ꦗThe monthly payment is $2,147.29, or $25,767.48 per year.

At the end of year one, you have made 12 payments, most of the payments have been towards interest, and only $3,406 of the principal is paid off, leaving a loan balance of $396,593. The next year, the monthly payment amount remains the same, but the principal paid grows to $6,075. Now fast forward to year 29 when $24,566 (almost all of the $♒25,767.48 annual payments) will go towards principal. Free or amortization calculators are easily found online to help with these calculations quickly.

Straight-Line vs. Effective-Interest Method of Amort🐷ization

Treating a bond as an amortized asset is an accounting method used by companies that issue bonds. It allows issuers to treat the 澳洲幸运5开奖号码历史查询:bond discount as an asset over the life of the bond until its maturity date. A bond is sold at a discount when a company sells it for less than its 澳洲幸运5开奖号码历史查询:face value and sold at a premium when the price receive🌳d is greater than fac🎉e value.

If a bond is issued 澳洲幸运5开奖号码历史查询:at a discount—that is, offered for sale below its par or face value—the discount must be treated either as an expense or it can be amortized as an asset. In this way, an amortized bond is used specifically for tax purposes because the amortized bond discount is treated as part of a company's interest expense on its income statement. The interest expense, a non-operating cost, reduces a company's 澳洲幸运5开奖号码历史查询:earnings before tax (EBT) and, therefore, the amount of ൲its tax burden.

Effective-interest and straight-line amortization are the two options for amortizing bond premiums or discounts. The easiest way to account for an amortized bond is to use the straight-line 🦄method of amortization. Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond.

Companies may also issue amortized bonds and use the 澳洲幸运5开奖号码历史查询:effective-interest method. Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period. Under this second type of accounting, the bond discount amortized is based on the difference between the bond's interest income and its interest payable. Effective-interest method requi🃏res a financial calculator or spreadsheet software to derive.