Accounting for Vanilla Bonds
Vanilla Bond is a type of bond which consist only some basic feature such as a fixed coupon rate, fixed term, fixed maturity date, and a pre-defined payment schedule. Bonds is the debt instrument that the company issue to the capital market and sell to investors. The company needs to pay regular interest as the return to the holders. At the end of the bond maturity date, investors will receive the amount stated on the bond which is called par value.
When a company issues a bond, it is agreeing to pay the holder of the bond a set amount of money (the “face value”) at a specific date in the future (the “maturity date”). In return, the investor provides the company with the invested capital. The bond payable account is used to record the face value of bonds that have been issued.
The account is initially debited when the bonds are issued, and it is subsequently credited when the bonds are paid off at maturity. Interest payments on bonds are recorded in a separate interest expense account. When a bond is first issued, the amount of the bond payable is equal to the face value of the bond. As interest payments are made, the balance in the bond payable account decreases. Ultimately, when the bond matures and is paid off in full, the balance in the bond payable account will be zero.
There are many kinds of bonds such as floating rate bonds, zero rate bonds, perpetual bonds, and so on. Vanilla bonds is one of the bonds which has only basic feature and straight to the point.
Vanilla Bond Features
- Fixed Coupon Rate: The issuer will pay interest base on the fixed coupon rate state on the bond. It will not change over time.
- Fixed Maturity Date: The maturity date is stated on the bond, the issuer must pay back the principal to the bondholder on this date.
- Fixed Face Value: Face value or par value is the amount that the issuer going to pay back on the maturity date.
Vanilla Bond Example
Company issue 6 years bond with a fixed coupon rate of 5% and par value is $ 1,000. Based on the features, we can see that the bond is a Vanilla bond.
The following is the future cash flow
| Year | Cash Flow |
|---|---|
| 1 | $ 50 |
| 2 | $ 50 |
| 3 | $ 50 |
| 4 | $ 50 |
| 5 | $ 50 |
| 6 | $ 1,050 |
In the bond lifetime, the investors expect to receive $ 1,300 of principal and interest.
Advantages of Vanilla Bonds
| Factors | Explanation |
|---|---|
| Easy to Value | Vanilla bond contains only the basic feature, so it is easy to estimate the valuation. If we compare to other types of bonds, Vanilla just takes into account the straightforward cash payment. |
| Low risk | This type of bond will generate fixed cash flow due to the fixed coupon rate. Moreover, the par value also fixed, so the risk is very low for the investor. |
| Easy convert to cash | Due to the low risk, many investors prefer Vanilla bonds. So selling them in the market is not the problem as many people willing to buy. |
Disadvantage of Vanilla Bonds
High-Interest rate
When interest rates rise, it’s generally bad news for investors. That’s because rising rates lead to higher borrowing costs, which can reduce profits and weigh down stock prices. In addition, rising rates can also cause the value of bonds to fall, as investors shift their money into higher-yielding investments. And finally, higher rates can lead to inflation, which can erode the purchasing power of investment income. As a result, investors need to be careful in how they position their portfolios when interest rates are on the rise. Otherwise, they may find themselves at a disadvantage.
Fixed Interest Rate
Fixed-rate bonds are a type of debt security that pays a fixed rate of interest over the life of the bond. Unlike other types of bonds, fixed-rate bonds cannot be called by the issuer and investors cannot use the put feature. As a result, fixed-rate bonds tend to be less volatile than other types of bonds and are often considered to be a safe investment. For this reason, fixed-rate bonds are often used by investors who are looking for a stable source of income. However, because of the lack of flexibility, fixed-rate bonds may not be suitable for all investors. Before investing in a fixed-rate bond, it is important to understand the risks and benefits associated with this type of investment.
Price Fluctuate
With interest rates on the rise, bond prices are falling. This is because when rates go up, the value of existing bonds goes down. As a result, investors are selling bonds and moving into other investments that offer higher returns. This can have a negative impact on the market for bonds, making it more difficult for new issuers to raise capital. However, there are some types of bonds that are less sensitive to changes in interest rates. These include shorter-term bonds and bonds with floating rates. As a result, investors may want to consider these types of bonds when rates start to rise.
Conclusion
Plain vanilla bonds are the most common type of bond, and they can provide investors with a stable source of income. The bonds have a fixed coupon rate, maturity date, and face value, so investors know exactly what they will receive. This predictability can be appealing to risk-averse investors who are looking for a consistent return. However, because these bonds lack special features, they often provide a lower return than other types of bonds. As a result, plain vanilla bonds may not be suitable for investors who are looking to maximize their return. Nonetheless, these bonds can be a useful tool for diversifying a portfolio and reducing risk.