Bullet Transaction
What Is a Bullet Transaction?
Bullet transaction is a term that alludes to a loan that requires the principal balance to be paid in full when it matures, as opposed to sharing it into portions over its lifetime. Borrowers just have to cover interest payments during the life of a bullet loan, basically until the last principal payment is required. Payment of the principal balance upon maturity is called a bullet payment.
How Bullet Transactions Work
The majority of loan contracts require the repayment of principal and interest over the long haul. So when a homeowner has a mortgage, for example, the lender amortizes the principal balance for the length of the loan — say, 30 years — figuring in interest payments in view of the loan's interest rate. The borrower is responsible to make standard payments until the balance is paid off in full.
Nonetheless, not all loans work something very similar. Bullet transactions expect borrowers to cover the full principal balance at the maturity date. Until the principal balance is due, they just pay interest. Bullet loans can be repaid by refinancing or by earning sufficient cash to repay the loan.
Mortgages that require bullet transactions are additionally called balloon mortgages. Mortgages and different loans that mature in 15 years are called 15-year bullets. Bullet transactions are priced as a number of basis points (BPS) over a benchmark like U.S. Treasuries. Investors can buy certificates to invest in bullet transactions.
Bullet transactions might have at least two tranches, each with various maturities and different interest rates.
Who Uses Bullet Transactions?
Bullet transactions are considerably less common than "ordinary" loans, in which the principal loan amount is paid off throughout the span of several payments. Nonetheless, bullet transactions are helpful for lenders or borrowers in a number of specific conditions.
For instance, bullet transactions are a decent option for franchisees, who may not quickly have sufficient money to cover the full cost of possessing a franchise. Bullet transactions allow them to foster cash flow through their business and save to the point of paying off the debt when it matures.
In different cases, companies might utilize bullet loans to create working capital to purchase equipment or finance an acquisition, among different purposes. Revolving loans and term loans can be structured as bullet transactions.
Even in these cases, notwithstanding, lenders might be reluctant to offer bullet transactions, since this model concentrates the risk of default. On the off chance that a franchisee can't generate cash flow rapidly, they might default on the whole amount of the loan.
Upsides and downsides of Bullet Transactions
The advantages and disadvantages of bullet transactions are different for the borrower and the lender.
For borrowers, the major benefit of a bullet transaction is that tiny repayment is due before the loan matures. This allows lenders to keep a greater amount of the capital that they generate in this period. Then again, bullet transactions will generally bring about borrowers paying more in interest, since they are not diminishing the principal over the lifetime of the loan.
For lenders, the image is unique. In spite of the fact that borrowers are simply required to make interest payments before maturity, bullet transactions can be very risky for lenders. That is a result of a greater chance that borrowers may default when the principal comes due. In the event that the borrower defaults, the lender may not get back any of the principal.
It's important to note that there are many types of bullet transactions, and some can be structured in additional complex ways. Some bullet transactions can have at least two tranches, for example, where various tranches have various maturities or different interest rates. This diminishes risk for the lender.
Also, bullet transactions can be utilized in numerous ways. A bullet bond is a debt instrument whose whole principal value is paid at the same time on the maturity date, rather than amortizing the bond over its lifetime. Bullet bonds can't be reclaimed right on time by an issuer, and that means that they are noncallable. Along these lines, bullet bonds might pay a generally low rate of interest due to the issuer's high degree of interest rate exposure.
Bullet Transaction Pricing Formula and Calculation
This is the way pricing for a bullet transaction works. To start with, the total interest payments for every period must be collected and discounted to their present value (PV). This is finished utilizing the following equation:
- PV = Pmt/(1 + (r/2)) ^ (p)
Where:
- PV = present value
- Pmt = total payment for the period
- r = bond yield
- p = payment period
For instance, envision a bullet bond with a par value of $1,000. The bond yields 5%, its coupon rate is 3%, and the bond pays the coupon two times a year over a period of five years. Given this data, there are nine periods where a $15 coupon payment is made, and one period — the last one — where a $15 coupon payment is made and the $1,000 principal is paid.
Utilizing the formula above, we can determine the payments during the life of the bond as illustrated in the table below:
| Period | Calculation | Present Value |
| 1 | $15 / (1 + (5% / 2)) ^ (1) | $14.63 |
| 2 | $15 / (1 + (5% / 2)) ^ (2) | $14.28 |
| 3 | $15 / (1 + (5% / 2)) ^ (3) | $13.93 |
| 4 | $15 / (1 + (5% / 2)) ^ (4) | $13.59 |
| 5 | $15 / (1 + (5% / 2)) ^ (5) | $13.26 |
| 6 | $15 / (1 + (5% / 2)) ^ (6) | $12.93 |
| 7 | $15 / (1 + (5% / 2)) ^ (7) | $12.62 |
| 8 | $15 / (1 + (5% / 2)) ^ (8) | $12.31 |
| 9 | $15 / (1 + (5% / 2)) ^ (9) | $12.01 |
| 10 | $1,015 / (1 + (5% / 2)) ^ (10) | $792.92 |
The Bottom LIne
A bullet transaction alludes to a loan that requires the principal balance to be paid in full when it matures, as opposed to sharing it into portions over its lifetime as in many mortgages. Borrowers are required to cover just the interest payments during the life of a bullet loan, basically until the last principal payment is required.
These loans can be repaid by refinancing or by earning sufficient cash to repay the loan and can be risky for lenders, as there's a greater chance that a borrower might default. For borrowers, the benefit is that tiny repayment is due before the loan matures. In any case, borrowers will likewise pay more in interest, since they are not diminishing the principal over the lifetime of the loan.
Highlights
- These loans can be exceptionally risky for lenders since there's a greater chance that a borrower might default.
- Borrowers just cover interest payments before the last payment is due.
- Bullet loans can be repaid by refinancing or by earning sufficient cash to repay the loan.
- A bullet transaction alludes to a loan that requires the principal balance to be paid in full when it matures, as opposed to sharing it into portions over its lifetime.
