DEFINITION of Bullet Transaction
A bullet transaction is a loan in which all principal is repaid when the loan matures instead of in installments over the life of the loan. When the loan is a mortgage, this can be referred to as a "balloon mortgage". A bullet transaction with a maturity of 15 years would be called a "15-year bullet."
With a bullet loan, only interest is paid during the entire loan term, until the final repayment. A bullet transaction may have two or more tranches, where the different tranches might have different maturities and/or different interest rates associated with them. A company might use a bullet loan for working capital, to purchase equipment or to finance an acquisition, among other uses. Revolving loans and term loans can be structured as bullet transactions.
BREAKING DOWN Bullet Transaction
A bullet loan can be repaid by refinancing or by earning enough cash to repay the loan. A bullet transaction entails greater risk for the lender because if the company does poorly, the lender may not get back any of the principal. 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.
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 they are non-callable. Because of this, bullet bonds may pay a relatively low rate of interest due to the issuer's high degree of interest rate exposure.
Pricing a bullet transaction proceeds as follows: First, the total interest payments for each period must be aggregated and discounted to their present value, according to the equation below.
Present Value (PV) = Pmt / (1 + (r / 2)) ^ (p)
Pmt = total payment for period
r = bond yield
p = payment period
For example, imagine a bullet bond with a par value of $1,000. Its yield is 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 to discount these payments is:
Period 1: PV = $15 / (1 + (5% / 2)) ^ (1) = $14.63
Period 2: PV = $15 / (1 + (5% / 2)) ^ (2) = $14.28
Period 3: PV = $15 / (1 + (5% / 2)) ^ (3) = $13.93
Period 4: PV = $15 / (1 + (5% / 2)) ^ (4) = $13.59
Period 5: PV = $15 / (1 + (5% / 2)) ^ (5) = $13.26
Period 6: PV = $15 / (1 + (5% / 2)) ^ (6) = $12.93
Period 7: PV = $15 / (1 + (5% / 2)) ^ (7) = $12.62
Period 8: PV = $15 / (1 + (5% / 2)) ^ (8) = $12.31
Period 9: PV = $15 / (1 + (5% / 2)) ^ (9) = $12.01
Period 10: PV = $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 principal is not repaid at any point except the very last (period 10), the hallmark of a bullet transaction.