What Is a Serial Bond With Balloon?
A serial bond with balloon is a bond for which portions of the total principal amount mature at staggered intervals and have a final payment significantly larger than the previous ones, called the balloon, owed at the end of the issue’s life.
A combination of a serial bond issue and a term bond issue, essentially, the serial bond with balloon has bonds that mature at different intervals throughout the issue's life, and then a large percentage of the bonds (the term bonds) mature in the last year of the issue's term.
- With serial bonds with balloon, portions of the total principal amount mature at staggered intervals, while the final payment is significantly larger.
- Low principal payments early on is one advantage of serial bonds with balloon.
- Payments of serial bonds with balloon occur more frequently in the high-yield corporate bond market.
Understanding Serial Bonds With Balloon
Typically, a serial bond with balloon covers a number of years. Only a portion of the loan's principal balance is amortized over the term. At the end of the term, the remaining balance is due as a final repayment.
A serial bond with balloon has some advantages for issuers, most notably, low principal payments in the early going. This helps corporate issuers with underlying businesses that have low cash flows currently but expect higher cash flows in later years.
However, issuing bonds and planning for a balloon maturity is sometimes risky from the issuer’s perspective. For example, if a company issues 500 serial bonds with balloon payments that mature in five years, the company must be able to cover the principal of all 500 bonds when serial payments come due, the balloon payment, in addition to all of the coupon payments for the duration of those years.
Let’s say this same company has a $200,000 serial bond with a balloon payment, with a coupon rate of 8%. The company must pay $20,000 every year toward the face value of various serial bonds. It also must pay coupon payments that decline each year, as the company retires more principal. However, it owes an additional $100,000 balloon payment in the final year.
Pros and Cons of Serial Bonds With Balloon
Serial bonds with balloon payments happen more frequently in the high-yield corporate bond market. Just as homeowners sometimes have mortgages with balloon payments, some corporations structure their debt in a similar way.
For some companies, serial bonds with balloons make sense, especially if the debt is callable. If cash flows are better than expected, the company simply pays off the balloon payment early for significant savings on interest payments.
However, some companies that issue serial bonds with balloon payments don’t have the needed cash to cover such a large payment near the end of the term. These companies must either have sufficient credit to refinance, or default on the payment.
In some instances, market participants invest in serial bonds with balloons as a way to generate incremental yield for their portfolios. Considerable research into the underlying fundamentals of the issuer must be performed before undertaking such an investment.
For most investors, however, serial bonds are rare. The bulk of most diversified U.S. bond funds, for example, invest in Treasury securities, mortgage-backed securities, asset-backed securities, and high-quality corporate credit, with perhaps a few other asset classes. High yield is either a fairly small percentage of such diversified funds, or it is excluded. For those with high-yield exposure, serial bonds are a small percentage of the high-yield component.