What is an Index Amortizing Note?
An Index Amortizing Note (IAN) is a type of structured note or debt obligation. The amount of the principal repayment will increase or decrease following an amortization schedule which has a basis of an index such as the LIBOR (London Interbank Offered Rate), the CMT (Constant Maturity Treasury), or the mortgage interest rate.
Understanding Index Amortizing Notes (IAN)
Index Amortizing Notes are structured to reduce the holders' interest rate risk. The IAN's maturity phase extends when interest rates increase. Conversely, as interest rates decline, the maturity period shortens. Amortization refers to paying off a debt over time in regular installments following an amortization schedule, which includes both interest and principal payments. With Index Amortizing Notes, the debt payment timeframe depends on the market interest rates.
Despite the ability to alter a note’s maturity period, the Index Amortizing Note also has a specified maximum maturity date. This maturity term is the date by which any remaining principal must be paid.
The maturities of index amortizing notes often act like those of collateralized mortgage obligations (CMOs) which have embedded prepayment options. As mortgage prepayment rates decline, in response to increasing market interest rates, the maturity of an IAN will lengthen. With an increase in mortgage prepayment rates, in response to decreasing market interest rates, the IAN maturity will shorten. As with other mortgage-backed instruments, an Index Amortizing Note's connection to interest rates creates a negative convexity exposure.
Using Indexes for an Index Amortizing Note
An interest rate index is an index based on the interest rate of a financial instrument or basket of financial instruments. The index serves as a benchmark to calculate the rate of interest to charge on mortgages and other debt products.
One example of an index schedule used for an Index Amortizing Note is the London Interbank Offered Rate (LIBOR). This LIBOR index is the benchmark rate which several of the top banks in the world charge one another for short-term loans. The LIBOR sets rates for seven different maturity periods and serves as the reference rate used by many financial institutions to set rates for loans such as mortgages, student loans, and corporate bonds. Lenders will adjust the interest rates on these loans according to the index as market factors change.
Comparing IANs with Non-Amortizing Loans
Unlike an Index Amortizing Note, non-amortizing loans have no amortization schedules. Also, they do not require the payment of the principal during the life of the loan. Instead, these loans demand lower payments of interest followed by a lump-sum amount to pay off the remaining loan balance. A balloon payment loan is an example of a non-amortizing loan. These loans are riskier for lenders because of the deferred payments and thus are usually short-term vehicles. Borrowers will often refinance, or seek another loan when the balloon payment is due.