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. Also known as an amortizing loan or bond, the principal paid off over the life of the loan is divvied up according to an 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, but as the loan matures, the interest will become lesser and the principal larger. The calculations for an amortizing loan are similar to that of an annuity using the time value of money, and can be carried out quickly using an amortization calculator.
A residential mortgage is one common example of an amortized bond, where if the interest rate is fixed, the monthly payment remains constant over its life of, say, 30 years. However, each payment will have a slightly different 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.
Amortization of debt affects two fundamental risks of bond investing: First, it greatly reduces the 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 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 weighted-average maturity (WAM) of the cash flows associated with the bond is lower.
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.
For example, you purchase a home with a $400,000 30-year fixed rate mortgage at 5 percent. The monthly payment would be $2,147.29, or $25,767.48 per year - and in the first year $3,406 of 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. By year 29, $24,566 of the $25,767.48 will go to principal. Free mortgage calculators or amortization calculators are easily found online to help with these calculations quickly.
Companies may also issue amortized bonds and use either the straight-line or the effective interest rate method to amortize bonds. Under this second method of accounting, the bond discount amortized each year is equal to the difference between the bond's interest expense and its interest payable. However, this method requires a financial calculator or spreadsheet software to derive.
If a bond is issued 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. 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 earnings before tax (EBT) and, therefore, the amount of its tax burden.
Specifically, amortization is an accounting method that gradually and systematically reduces the cost value of a limited-life, intangible asset. Treating a bond as an amortized asset is an accounting method in the handling of bonds. Amortizing a bond allows issuers to treat the bond discount as an asset over the life of the bond until its maturity date.