Explain the ways a bond's principal can be paid back
The idea
A bullet bond repays the entire principal at maturity, so the issuer faces a single large refinancing and the holder a stable balance. An amortising bond repays principal gradually with each payment, reducing credit exposure over time and shortening the effective life below the stated maturity. A sinking fund provision requires the issuer to retire a portion of the issue each year, often by lot, which reduces credit risk but exposes an individual holder to having their bond redeemed early at a price that may be below market. Weighted average life describes the timing of repayment better than stated maturity for amortising structures.
A practice question
What does a sinking fund provision require of an issuer?
- To deposit the full principal with the trustee at issuanceWhy not: That would be a defeasance or escrow arrangement, and it would defeat the purpose of borrowing. A sinking fund retires debt progressively out of cash flow.
- To retire a portion of the issue each year before maturity — correct
- To repurchase bonds whenever their price falls below parWhy not: Retirement follows a schedule set in the indenture, not the market price. An issuer free to buy only when bonds were cheap would give holders no protection.
Retiring debt on a schedule spreads the repayment burden instead of leaving a single large obligation at maturity, which is the credit benefit the provision exists for.
A harder one
What risk does a sinking fund provision create for an individual bondholder?
- That the issuer will default on the remaining bondsWhy not: The provision reduces default risk by shrinking the amount outstanding. That is the credit benefit it exists for.
- That the coupon will be reducedWhy not: The coupon is fixed in the terms. What changes is how many of a holder's bonds remain outstanding.
- That their particular bonds may be redeemed early at a price below market value — correct
Selection is usually by lot. A holder whose bonds are drawn when the bond trades above the redemption price loses that premium, which is the cost of the provision's credit benefit.
The hardest tier
Why is weighted average life a better description of an amortising bond than its stated maturity?
- Because most principal is repaid earlier — correct
- Because stated maturity is not disclosed for amortising bondsWhy not: It is disclosed like any other term. The problem is that it describes the last payment rather than the typical one.
- Because weighted average life includes coupon paymentsWhy not: It weights the *principal* repayments by when they arrive. Including coupons would be closer to Macaulay duration.
Stated maturity overstates how long capital is at risk. A thirty-year amortising loan may return half its principal within a decade, so pricing or measuring risk against the final date would badly misstate the exposure.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →