What is a Balloon Interest
Balloon interest is an increased coupon rate on long-term maturity instruments within a serial bond issue, known as a serial bond with a balloon. In a serial-issue, bonds mature at different intervals, creating a string of short- to long-term instruments.
In a serial bond issue, all the bonds mature in intervals, unlike a term issue, where all the bonds have the same maturity date.
BREAKING DOWN Balloon Interest
The creation of ballon interest in a serial bond issue happens when bonds mature at regular intervals with a significant portion of the bonds maturing at the same time, in either the first or last interval. This significant amount maturing at once creates the balloon.
A serial bond is a bond issue that is structured so that a portion of the outstanding bonds mature at regular intervals until all of the bonds have matured. Because the bonds mature gradually over a period of years, these bonds are used to finance projects that provide a consistent income stream for bond repayment. The entire bond issue sells to the public on the same date, with maturity dates shown in the offering documents.
With serial issued, long-term bonds, higher interest earnings are possible. Higher profits provide an incentive to investors to hold the instrument longer. Investors refer to this large coupon rate as balloon interest.
Serial bonds are usually issued to fund revenue-generating projects which have a steadily increasing cash flow. The issuer anticipates that the project will be near the height of its earning power by the time the balloon interest is due.
When many or a majority of the bonds mature at one time, it is called a serial bond with balloon. The balloon is due to the large percentage of the term bonds maturing in the last year of the issue's term. Alternatively, the bulk of the bonds may mature at the first maturity date with the rest of the bonds gradually maturing over the remainder of the issue's life.
Calculating Bond Interest Rates
The actual, real, or effective interest rate of a bond is the rate that will discount all of the future cash receipts back to the amount of cash paid to buy the bond. This interest rate is also known as the yield to maturity, yield, and market interest rate.
To calculate the actual or real interest rate on a bond, an investor can use present value software or a financial calculator. The future cash receipts for a typical bond are the semiannual interest payments. In other words, it is the bonds interest rate, times the face amount of bond, times one-half of a year, added to the maturity amount of the bond.
The interest payments form an ordinary annuity, and the maturity amount is a single payment. If the bond's stated interest rate is less than the current market interest rate, the bond's market value is less than the maturity or face amount of the bond. The bond will sell at a discount. When the bond's interest rate is higher than the current market interest rate, it will have a market value which is more than the maturity or face amount of the bond. The bond will sell at a premium.
There are also zero-coupon bonds, which do not pay interest but are traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value. Because zero-coupon bonds pay at maturity, their pricing tends to be more volatile than coupon bond pricing.