Bonds usually pay interest only and the entire principal is paid back at maturity. On the other hand fixed rate retail loans pay back both interest and principal such that at the end no debt is remaining.

To me, the latter seems to be more manageable. The borrower never need to pay back a lump sum of money at the same time.

Why do governments and companies prefer the first structure of payments when borrowing money instead of paying annuity?

  • They just issue new debt to roll over the principal anyway. Unlike individuals, they do not have a fixed life span.
  • Trading amortising bonds in the secondary market is a pain, since you then need to keep track of the amortising schedule when pricing them. (This point was discussed in comments. The calculations for amortising bonds in 2018 are straightforward, but not in the era before digital computers, and that is when bond market conventions were developed.) Vanilla bonds with the same maturity and coupon are effectively identical, but this is not true for two amortisers with different maturity dates. Although this does not appear to be an issue now; trading conventions were largely determined in the pre-digital computer age. For example, the principal amount on a bond is used in for default recovery purposes; that is equal to the face value of a bullet bond, but has to be determined for an amortising bond, which is an awkward calculation to be done on the fly without access to digital computing technology.
  • One added note is that straight amortising bonds have a very low duration relative to a bullet principal payment. Many investors want to get as much duration as possible for a given investment amount.
  • $\begingroup$ I don't get the second point. Why? Pricing of the bonds is determined by the chosen discount rate and cash flows. The same can be done for amortizing bonds too, basically the only difference is there is no principal cash flow at the end. $\endgroup$ – Calmarius Nov 20 '18 at 13:43
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    $\begingroup$ More data to keep track of. A vanilla bond just has face value, coupon, maturity date that determine its pricing parameters. (Things like coupon frequency normally follow market convention.) An amortiser has an amortisation schedule. In a world of digital computing, this is not that big a deal, but it would raised far more issues before the 1980s. Market conventions were set long before that. $\endgroup$ – Brian Romanchuk Nov 21 '18 at 21:54
  • $\begingroup$ I still don't get it. To get the correct price of the bond one needs to do the discounted cash flow analysis anyway. Or is this DCF a relatively new invention? $\endgroup$ – Calmarius Nov 24 '18 at 19:40
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    $\begingroup$ Back in the day, they got the price of bonds by looking it up in books. The principles of DCF were known, but how do you calculate it without a digital computer? Even with digital computers, you still need to specify an amortisation schedule. It’s obviously possible to calculate (amortising bonds exist), but it’s a pain. Mortgage payments were also specified by looking them up in books. $\endgroup$ – Brian Romanchuk Nov 25 '18 at 22:18
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    $\begingroup$ That actually illustrates why traded markets historically avoided amortising bonds. With a bullet bond, you know the principal amount, which is what post-default recovery is based on. With an amortising bond, you would have to calculate the amortised principal to know what your credit exposure is on a given face amount. How are bond traders going to do that quickly when all they have access to is pen, paper, and possibly an abacus or slide rule? $\endgroup$ – Brian Romanchuk Nov 27 '18 at 22:52

I agree it can seem counter-intuitive, compared to a normal loan, but there are some different characteristics for bonds. Here are some points that come to mind:

Fixed income stream. By not repaying the principal, and having a fixed interest rate, it is known exactly how much the bond holder will receive in income (and how much the issuer will have to pay). This is quite helpful for both sides, plus it helps with understanding its value for trading it on the secondary market.

Cash flow. By not having to to repay principal over the life of the bond, it allows the borrower to utilise more of the cash up front (for investment etc) and it can either make a plan to repay the principal later (like an interest only mortgage) or rollover the debt by issuing another bond to pay for the redemption (as generally happens with governments).

Historical precedent. Bonds have existed for a very long time, when the physical piece of paper was the asset and you had a literal coupon to claim interest. This was probably quite a nice and simple way of agreeing debt obligations. There are even perpetual bonds, which have no maturity date!


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