A plain vanilla bond has a maturity of 5 years, a par value of $1,000 and a coupon rate of 6%. Interest payments are made annually. Assume the market interest rate is a constant 6%. The bond is issued at par. The principal repayment the first year is closest to:
a) $0
b) $177.40
c) $237.40
For this question, when we work out the PV it is equal to $1000, as is the FV. Do we know that the principal repayment is $0 becuase both PV and FV are equal (as bond was initially issued at par)? i.e. If the PV was not equal to the FV, then would the principal repayment in the first year be PV/5?
The answer comes from the words “plain vanilla bond”. By definition, the bondholder gets regular coupon payments (interest). The bondholder gets the whole of the principle (face value) at maturity, along with the final coupon payment. The payment in the first year is $60. This is 100% interest and 0% principle repayment.
Other exam words that lead to the same answer are ‘non-amortizing’ or the bond has a ‘bullet structure’.
If the PV was different from the FV, then you would amoratize the bond depending on the discount or premium.
In reality, there is no principal repayments until maturity, but the interest expense and the difference between issue price and par value is smoothed out along the term.
Proper recognition of interest expense and bond amortization on the income statement is found in the reading of long term liabilities.
If the bond is issued at a premium or a discount, the premium or discount is amortized over the life of the bond. It isn’t a principle payment per se, but it’s treated like a principle payment for financial accounting purposes: it changes the interest expense reported and changes the liability shown on the balance sheet.
Under IFRS, you must use the effective interest rate method to amortize a bond premium/discount; the amortization will change from year to year. Under US GAAP, it is preferred that you use the effective interest rate method, but you can use straight-line amortization (same amount each year) if the difference is not material.