Serial Bond Definition Examples What Is A Serial Bond

Serial Bond Definition

Serial bonds, unlike bullet or term bonds that repay the entire principal at the time of maturity, repay it in installments at regular intervals, i.e., the entire issue consists of multiple securities or CUSIP of varying maturities and each such CUSIP or a bunch of CUSIP numberCUSIP NumberCUSIP is an abbreviation for the Committee on Uniform Securities Identification Procedures. It is a unique identification code assigned to most financial instruments, including stocks registered with all American and Canadian corporations, commercial papers, and US government and municipal bonds.read more matures at a different time according to a repayment schedule specified in the bond indentureBond IndentureBond indenture or bond resolution is a core legal document that serves as a contract binding upon the bond issuer and the bondholder. It comprises all the bond-related information, like details of the issue, its purpose, bond issuer’s obligations and rights of the bondholders.read more.

Generally, these are issued by the center, state governments or municipalities to finance large public works projects, such as highways, toll roads, flyovers, schools, etc. The projects require huge investment at the initial phase, and after these projects start generating revenues, a consistent and regular stream of cash flow is expected. These revenues are used to pay off the debt. Therefore they are sometimes also known as revenue bondsAs Revenue BondsRevenue bonds are bonds issued by municipal corporations where the revenue from income-producing projects such as toll bridge, highway, sewer facilities, airport construction, roads, local stadium are used in repaying the debt obligation (both interest and principal component).read more.

In comparison to amortizing bonds, which consist of a single maturity bond, a Serial bond issue consists of multiple maturity bonds. In amortizing bonds, a part of every payment consists of principal and the remaining part of interest, while for serial bonds, the principal is repaid on specific dates.

Example of a Serial Bond

The following are examples of serial bonds.

Example #1

Let us suppose that the issuer issues serial bonds worth $10 million on 1st January 2010 at 10% annual interest payableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company’s balance sheet.read more on December 31st every year. The issuer also specifies the following repayment schedule:

The following inferences can be made from the table above:

Till December 31st, 2014 entire $10 million is due to the annual interest is $1 millionTill December 31st, 2015, the entire $10 million is due to the annual interest of $1 million. However, on this date, $2 million is redeemed, leaving the balance of $8 million for the years to comeOn each subsequent December 31st, $2 million is redeemed, reducing the balance by $2 million for the years to come and thereby reducing the interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more accordingly

Example #2 – County of Ulster

As mentioned earlier, Municipalities are one of the issuers of serial bonds and are governed by the Municipal Securities Rulemaking Board (MSRB) in the US. They have an electronic database of the bonds issued by them, which contain all the information on their serial bond issues as well. This database is called Electronic Municipal Market Access (EMMA).

Serial bond issues can be accessed on this website: emma.msrb.org.

This website also contains detailed official statements released by the issuers on several such issues, which give information such as the repayment schedule, taxability of the issue, present financial position of the issuer, companies, or institutions which are liable to pay off the issues, etc. Following is one such issue:

In this issue, general obligation serial bonds worth $5,280,000 were issued as per their official statement dated August 1st, 2019, for improvements of public real estate.These will become due for redemption on November 15, 2019-2027, and are not subject to redemption prior to maturity, i.e., any date before and the principal redemption schedule is as follows:

Source: County of Ulster, New York Public Improvement (Serial) Bonds: official statement dated August 1st, 2019

The securities under this issue are of denominations of $5000 each.A purchase will be made on the book-entry system only, i.e., there will be no physical transfer of bond, only transfer entries will be made in the books of Depository Trust Company (DTC) and direct/indirect participants.The county will generate revenues by levying taxes on real estateTaxes On Real EstateEstate tax refers to the tax on the privilege, allowing owners to exercise the right to transfer their property to legal heirs after they die or under other circumstances as per the law.read more within the procedures, limitations, and formula set forth by the “Tax levy limitation law.”The revenue generated is transferred down the chain through DTC for payment of interest and principal.Following is the flow of securities and cash flow.

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The County spreads the word that the bonds are being issued, and this is trickled down to bondholders via a chain of DTC who, in turn, inform the direct/indirect participants.Prospective bondholders approach their nearest participant and express their interest in purchase and deposit funds for the same.Participants convey the word up the chain.The county is responsible for delivering the securities down the chain.The same chain is followed for interest and principal paymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan’s original amount is directly reduced.read more.This flow is maintained to achieve deeper penetration of securities.

Advantages of Serial Bonds

Lowers default risk: As the principal is repaid in installments at regular intervals, not the entire amount becomes due on one single date, and therefore it reduces the instances of default with each such repayment by reducing the impact of unforeseen future events which might lead to unavailability of large sum on the single maturity date.Attracts more investors: Investors with different time horizons can invest in these bonds depending upon their investment needs. Therefore these bonds are lucrative for a wider pool of investors. Further, interest rates also vary. Shorter maturity bonds have lower interest rates, while longer ones have higher interest rates to compensate the investor for undertaking higher risk.Reduced cost of debtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more: Issuers prefer these as they reduce interest liability with each principal repayment date. This leads to a lower weighted average interest cost in comparison with a bullet bondA Bullet BondBullet Bonds (also known as Straight Bonds) are standard bonds that pay interest on a periodic basis and repay the principal amount when the bond matures. They don’t have any exotic features like embedded call or put features. These bonds do not have a principal amortization schedule, therefore their principal amount remains constant throughout the term and is only payable at the end.read more.

Disadvantages of Serial Bonds

Reinvestment risk: Although these reduce the default risk for the investors, they create reinvestment risk if the interest rate environment is declining. Investors may need to make use of derivative contractsDerivative ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more such as forward rate agreements, or swaps or options to hedge against such fluctuation in the interest rates, which is an additional cost, or may bear the reinvestment risk.Inappropriate for some projects: These should be issued only for the projects which generate consistent and regular cash inflows to pay off the principal installments, and if such projects face a certain setback, they lead to piling up of obligation very early in the project.

Conclusion

To sum up, the striking feature of the serial bonds is the repayment schedule, which makes it appropriate for investors of different time horizons. These bonds are issued mainly by the government to fund projects which will provide regular income in the future, which is used to repay the debt of the issue. There can be corporate issues too, but that’s not very common.

They pose a trade-off for the investors between the default risk and the reinvestment risk, whereas the trade-off for the issuers is in terms of lower interest rate and earlier principal repayment.