What Is a Bullet Transaction?
Bullet transaction is a term that refers to a loan that requires the principal balance to be paid in full when it matures, rather than dividing it up into installments over its lifetime. Borrowers only need to cover interest payments during the life of a bullet loan, at least until the final principal payment is required. Payment of the principal balance upon maturity is called a bullet payment.
- A bullet transaction refers to a loan that requires the principal balance to be paid in full when it matures, rather than dividing it up into installments over its lifetime.
- Borrowers only cover interest payments before the final payment is due.
- Bullet loans can be repaid by refinancing or by earning enough cash to repay the loan.
- These loans can be very risky for lenders because there’s a greater chance that a borrower may default.
How Bullet Transactions Work
The majority of loan contracts require the repayment of principal and interest over time. So when a homeowner has a mortgage, for instance, the lender amortizes the principal balance for the length of the loan—say, 30 years—factoring in interest payments based on the loan’s interest rate. The borrower is responsible to make regular payments until the balance is paid off in full.
However, not all loans work the same. Bullet transactions require borrowers to cover the full principal balance at the maturity date. Until the principal balance is due, they only pay interest. Bullet loans can be repaid by refinancing or by earning enough cash to repay the loan.
Mortgages that require bullet transactions are also called balloon mortgages. Mortgages and other loans that mature in 15 years are called 15-year bullets. Bullet transactions are priced as a number of basis points (BPS) over a benchmark such as U.S. Treasuries. Investors can buy certificates to invest in bullet transactions.
Bullet transactions may have two or more tranches, each with different maturities and different interest rates.
Who Uses Bullet Transactions?
Bullet transactions are much less common than “regular” loans, in which the principal loan amount is paid off over the course of several payments. However, bullet transactions are useful for lenders or borrowers in a number of specific circumstances.
For example, bullet transactions are a good option for franchisees, who may not immediately have enough money to cover the full cost of owning a franchise. Bullet transactions allow them to develop cash flow through their business and save enough to pay off the debt when it matures.
In other cases, companies may use bullet loans to develop working capital to purchase equipment or finance an acquisition, among other uses. Revolving loans and term loans can be structured as bullet transactions.
Even in these cases, however, lenders may be hesitant to offer bullet transactions, because this model concentrates the risk of default. If a franchisee cannot generate cash flow quickly, then they may default on the entire amount of the loan.
Pros and Cons of Bullet Transactions
The pros and cons of bullet transactions are different for the borrower and the lender.
For borrowers, the major benefit of a bullet transaction is that very little repayment is due before the loan matures. This allows lenders to keep more of the capital that they generate in this period. On the other hand, bullet transactions tend to result in borrowers paying more in interest, because they are not reducing the principal over the lifetime of the loan.
For lenders, the picture is different. Although borrowers are only required to make interest payments before maturity, bullet transactions can be very risky for lenders. That’s because of a greater chance that borrowers may default when the principal comes due. If the borrower does default, then the lender may not get back any of the principal.
It’s important to note that there are many types of bullet transactions, and some can be structured in more complex ways. Some bullet transactions can have two or more tranches, for instance, where different tranches have different maturities or different interest rates. This reduces risk for the lender.
Similarly, bullet transactions can be used in many ways. A bullet bond is a debt instrument whose entire principal value is paid all at once on the maturity date, as opposed to amortizing the bond over its lifetime. Bullet bonds cannot be redeemed early by an issuer, which means that they are noncallable. Because of this, bullet bonds may pay a relatively low rate of interest due to the issuer’s high degree of interest rate exposure.
Bullet Transaction Pricing Formula and Calculation
Here’s how pricing for a bullet transaction works. First, the total interest payments for each period must be aggregated and discounted to their present value (PV). This is done using the following equation:
- PV = Pmt / (1 + (r / 2)) ^ (p)
- PV = present value
- Pmt = total payment for the period
- r = bond yield
- p = payment period
For example, imagine a bullet bond with a par value of $1,000. The bond yields 5%, its coupon rate is 3%, and the bond pays the coupon twice per year over a period of five years. Given this information, there are nine periods where a $15 coupon payment is made, and one period—the last one—where a $15 coupon payment is made and the $1,000 principal is paid.
Using the formula above, we can determine the payments during the life of the bond as outlined in the table below:
|1||$15 / (1 + (5% / 2)) ^ (1)||$14.63|
|2||$15 / (1 + (5% / 2)) ^ (2)||$14.28|
|3||$15 / (1 + (5% / 2)) ^ (3)||$13.93|
|4||$15 / (1 + (5% / 2)) ^ (4)||$13.59|
|5||$15 / (1 + (5% / 2)) ^ (5)||$13.26|
|6||$15 / (1 + (5% / 2)) ^ (6)||$12.93|
|7||$15 / (1 + (5% / 2)) ^ (7)||$12.62|
|8||$15 / (1 + (5% / 2)) ^ (8)||$12.31|
|9||$15 / (1 + (5% / 2)) ^ (9)||$12.01|
|10||$1,015 / (1 + (5% / 2)) ^ (10)||$792.92|
Adding up these 10 present values equals $912.48, which is the price of the bond. Note that the principal balance is not repaid at any point except the very last period—the hallmark of a bullet transaction.
The Bottom LIne
A bullet transaction refers to a loan that requires the principal balance to be paid in full when it matures, rather than dividing it up into installments over its lifetime as in most mortgages. Borrowers are required to cover only the interest payments during the life of a bullet loan, at least until the final principal payment is required.
These loans can be repaid by refinancing or by earning enough cash to repay the loan and can be risky for lenders, as there's a greater chance that a borrower may default. For borrowers, the benefit is that very little repayment is due before the loan matures. However, borrowers will also pay more in interest, because they are not reducing the principal over the lifetime of the loan.