What are Serial Bonds?
Definition: Serial bonds are debt securities issued at once but mature at different dates. Usually, bonds are issued to enable the issuer to access capital for income generating projects. It becomes necessary to issue serial bonds to reduce the risk of defaulting.
This is because the issuer will repay the bondholders at different dates, which lessens the burden of repayment. On the contrary, term bonds mature at the same time, which places a huge financial burden on the issuer.
Serial Bond Example
The attractiveness of serial bonds is that issuers wiggle from under the weight of debt far quicker. While the issuers acquire substantial funds to finance their projects, the pay back the money at regular intervals. Say an issuer sells serial bonds worth $1,000,000. According to the bond indenture, 20% of the debt matures after 5 years. Further, 30% of the debt matures after 10 years, and the remaining 50% matures after 20 years.
Truthfully, investing in securities is risky especially in a roiled global economy. It is even riskier to invest in securities that compound risk like derivatives. However, debt securities like bonds are safer because the chances of a government defaulting are minimal. Still, there is evidence of creditors who have had to settle for a huge loss when governments defaulted on their bonds. Especially, the likelihood of a default is elevated when the bond matures at once. From the foregoing, investors feel safer with serial bonds because the issuer pays back the loan in manageable bits.
Serial Bond Issue vs Traditional Bond Issue
To understand the significant difference between serial bond issues and traditional bond issues, consider this example. A municipal authority in New York wants to construct a thoroughfare that stretches for distance of 60 kilometers. According to preliminary studies, the project will need $200 million from start to completion.
The municipality wants to raise the funds from a 10-year bond issue but authorities are unsure how to go about it.A consultant has been brought in to help the authorities choose between a traditional bond issue and a serial bond issue.
In a presentation, the consultant breaks down the two bond issues as shown below.
| Serial Bond Issue | Traditional Bond Issue | |
| Year 1 | $0 | $0 |
| Year 2 | $0 | $0 |
| Year 3 | $0 | $0 |
| Year 4 | $0 | $0 |
| Year 5 | $0 | $0 |
| Year 6 | $40,000,000 | $0 |
| Year 7 | $40,000,000 | $0 |
| Year 8 | $40,000,000 | $0 |
| Year 9 | $40,000,000 | $0 |
| Year 10 | $40,000,000 | $200,000,000 |
In the two scenarios, the structure of bond issue differs significantly. In the traditional bond issue, the bond matures at once during the tenth year. As such, the municipality will have to repay the entire principal sum of $200 million together with interest at the same time. In the serial bond issue, the authorities can structure the bond such that the $40 million natures after five years (during Year 6).
Thereafter, the authority will repay $40 million every year until the loan is completely repaid during Year 10.
Why the difference in bond issue structure matters?
To be sure, the structure of the bond issue is critical but this is contingent on the type of project that the loan is funding. For instance, the municipal authority in the example above is borrowing to build a road. Usually, roads open in stages, which mean the authority will earn revenue in stages. If the authority issues a term bond, it will have to pay coupons on $200 million for 10 years. At the maturity of the loan, the authority will have to pay the principal sum and interest. In this case, the authority will pay more because the interest rate is huge.
If the authority issues a serial bond, it will begin paying lower coupon rates after Year 6. The coupon rate will continue to reduce as the authority pays off $40 million yearly. Also, the interest rate that the municipality will pay is less. The interest rate continues to reduce as the size of the principal sum decreases.