Term Bond: What it is, How it Works, Different Types
But they are used by some investors as a gift to younger investors, especially because of their use in funding higher education. That said, a dedicated annual purchase program can create an I bond “ladder,” which can amount to a much larger amount over time. I bonds may represent a convenient way for newer investors to start a bond portfolio alongside their stock portfolio. The predictability and assumed principal protection provided by these bonds stands out versus bond funds which can fluctuate in price.
Serial bonds can diversify retirement portfolios to keep a steady stream of income coming in at staggered intervals. As you can see, term bonds have a single maturity date, which means that your investment is tied up for the entire term. On the other hand, serial bonds have multiple maturity dates, offering more frequent cash flows. Term bonds have lower refinancing risk compared to serial bonds, as the issuer does not need to constantly refinance the debt. However, term bonds may have decreased value if interest rates rise.
Assume, for example, that a city builds a sports stadium that is funded with parking fees, stadium concession income, and lease income. As the total amount of bonds outstanding decreases, the future risk of the bond issue defaulting also declines. If an issuer reduces the dollar amount of bonds outstanding, it reduces the risk that the issuer misses a principal repayment or interest payment and defaults on the bond issue. While a serial bond issue requires the issuer to repay specific bondholders on a stated date, other bond issues are structured with a sinking fund. The financial accounting phrases term and serial bonds refer to indentures or contracts entered into by companies that represent a promise to pay.
- Treasury bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons.
- Investors must review all decisions in the context of their personal investment objectives.
- Firstly, they provide a predictable stream of income through regular coupon payments, which can be advantageous for those seeking a stable source of cash flow.
Term bonds and serial bonds both offer investors a low-interest return on investment, but both are relatively risk-free investment strategies. The purpose of these two types of bonds is funding projects or company goals with the intention of repayment with interest at maturity. Although they’re not huge money-makers, serial and term bonds put your money to work for you. Term bonds and serial bonds are the opposite of one another concerning their maturity rates. If you’re considering an investment in either type of bond, it’s wise to read the fine print before signing the agreement. Some term bonds carry a stipulation for repayment before the maturity date.
Other features of a term bond
The interest payment (“coupon payment”) divided by the current price of the bond is called the current yield (this is the nominal yield multiplied by the par value and divided by the price). There are other yield measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity. The quality of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. In other words, credit quality tells investors how likely the borrower is going to default. High-yield bonds are bonds that are rated below investment grade by the credit rating agencies.
Serial bonds differ in that they come with various maturity dates that are spread out over a period of several years. They’re referred to as serial bonds because of the staggered maturity dates. Unlike term bonds, serial bonds do not use sinking funds as security. Funds for repayment of the bond are used from the revenues generated from the project that has been funded by the sale of the bonds.
What Is a Serial Bond With Balloon?
Serial bonds are not suitable when the cash flows expected to be generated by a project funded with the bonds will be irregular, delayed, or uncertain. In such cases, structuring a bond as a serial bond could result in a default rather early in the buy-back period. Whether it is a term bond or a serial bond, the process is the same. All the amounts to be recorded over the four-year life of this bond can be computed to verify that the final payment does remove the debt precisely. Term bonds can be backed by specific collateral (secured term bonds), where the collateral is set aside to secure the bonds if they cannot be repaid at maturity. In other words, a serial bond matures in steps where a portion of the principle is payable at specific dates during the bond’s life.
Understanding Serial Bonds
Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses.
The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. The advantage to the issuer of a serial bond is that less interest will be paid over the life of the bonds, since the aggregate amount of cash loaned to the issuer is greatly reduced. The advantage to the investor is the reduced risk of default, since the issuer’s repayment liability is constantly declining. A sinking fund is a set-aside of cash that is used by a trustee to retire bonds by buying them on the open market from any bondholder willing to sell them. Conversely, a serial bond is designed to retire bonds in accordance with a specific schedule. In both cases, the amount of bonds outstanding will decline over time.
Let’s say this same company has a $200,000 serial bond with a balloon payment, with a coupon rate of 8%. The company must pay $20,000 every year toward the face value of various serial bonds. It also must pay coupon payments that decline each year, as the company retires more principal. However, it owes an additional $100,000 balloon payment in the final year.
However, some companies that issue serial bonds with balloon payments don’t have the needed cash to cover such a large payment near the end of the term. These companies must either have sufficient credit to refinance, or default on the payment. A term bond can be contrasted with a serial bond, which has various maturity schedules set at regular intervals until the issue is retired.
Advantages of Serial Bonds
Term bonds may come with a sinking fund requirement, where the company sets aside an annual fund to repay the bond. Some companies also offer “secured term bonds” in which they promise to back their bond with company collateral or assets, in case they fail to repay the stated amount of the bond upon maturity. Their term bonds remain “unsecured,” in which case investors must rely upon the company’s credibility and history. The issuer of a serial bond may reduce the dollar amount of outstanding bonds to reduce the risk of missed principal repayments or default on the bond issue. Serial bonds are common for municipal revenue bonds to fund projects undertaken by cities and states. An example of such a project is a sports stadium with serial bonds sold for the funding.
As these bonds are riskier than investment grade bonds, investors expect to earn a higher yield. The coupon is the interest rate that the issuer pays to the holder. For fixed rate bonds, the coupon is fixed throughout the life adjusting journal entries of the bond. Treasury savings bond program, designed to offer low-risk investments to a broad audience. They are based on a “composite interest rate,” which combines a fixed interest rate and a variable inflation-linked rate.
Serial bonds, on the other hand, are subject to higher refinancing risk and reinvestment risk for investors. Investopedia also defines the details of a serial bond in another segment. Guest Author James Chen explains that the structure of the serial bonds mature at regular intervals until all of the purchased bonds have matured. The total bond issue is purchased on the same date with offset dates for maturity as stated in the agreement/prospectus signed by the issuer and the purchaser. Serial bonds have unique advantages for both issuers and investors. For issuers, serial bonds can help to spread out the repayment of principal over a longer period, reducing the strain on their cash flow.