Bullet Bond

Bullet Bonds are bonds that require payment of the entire principal amount at once upon reaching maturity while spreading the interest payments over the entire period. These options are not callable, i.e., they cannot be redeemed beforehand by the issuers. The transaction closes only when the bond matures.

Bullet Bonds are the most common and widely issued bonds across the globe. Banks and financial institutions 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.

Bullet bonds refer to the debt investment instruments whereby the principal is paid at once when the maturity period is reached and the interest is spread across the entire term. This payment of principle at one go is what makes these bonds known as bullet bonds, as bullets fire all at once. These bonds aren’t principal amortized and their principal amount remains the same throughout the tenure and payable only at the end of the tenure.

Also known as straight bonds, 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 risk associated with any other issuer other than the government.

Bullet bonds, be it for short-term or long-term, collectively build the bullet bond portfolio of an investor.

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.

Let us consider the following instances to understand bullet bond meaning and its working properly:

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 yield 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 payment individually, as shown below:

As the entire principal is to be paid all at once, the burden is comparatively less on firms and individuals liable to paying off for their debt instruments. This is because they get time to gather a lump sum by the time these debt instruments mature. Besides this, there are other benefits as well that these options offer issuers, which include the following:

• 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 risk on the principal portion for the investor in this case.

Besides the benefits these options offer, there are many limitations that one must know about before considering them. Let us have a look at some of them below:

• It carries a high amount of Interest Rate Risk 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.