What Is an Amortized Bond?

An amortized bond is one in which the principal (face value) on the debt is paid down regularly, along with its interest expense over the life of the bond. A fixed-rate residential mortgage is one common example because the monthly payment remains constant over its life of, say, 30 years. However, each payment represents a slightly different percentage mix of interest versus principal. An amortized bond is different from a balloon or bullet loan, where there is a large portion of the principal that must be repaid only at its maturity.

Understanding Amortized Bonds

The principal paid off over the life of an amortized loan or bond is divvied up according to an amortization schedule, typically through calculating equal payments all along the way. This means that in the early years of a loan, the interest portion of the debt service will be larger than the principal portion. As the loan matures, however, the portion of each payment that goes towards interest will become lesser and the payment to principal will be larger. The calculations for an amortizing loan are similar to that of an annuity using the time value of money, and can be carried out quickly using an amortization calculator.

Amortization of debt affects two fundamental risks of bond investing. First, it greatly reduces the credit risk of the loan or bond because the principal of the loan is repaid over time, rather than all at once upon maturity, when the risk of default is the greatest. Second, amortization reduces the duration of the bond, lowering the debt’s sensitivity to interest rate risk, as compared with other non-amortized debt with the same maturity and coupon rate. This is because as time passes, there are smaller interest payments, so the weighted-average maturity (WAM) of the cash flows associated with the bond is lower.

Example of Amortizing a Bond

30-year fixed-rate mortgages are amortized so that each monthly payment goes towards interest and principal. Say you purchase a home with a $400,000 30-year fixed-rate mortgage with a 5% interest rate. The monthly payment is $2,147.29, or $25,767.48 per year.

At the end of year one, you have made 12 payments, most of the payments have been towards interest, and only $3,406 of the principal is paid off, leaving a loan balance of $396,593. The next year, the monthly payment amount remains the same, but the principal paid grows to $6,075. Now fast forward to year 29 when $24,566 (almost all of the $25,767.48 annual payments) will go towards principal. Free mortgage calculators or amortization calculators are easily found online to help with these calculations quickly.

Straight-Line vs. Effective-Interest Method of Amortization

Treating a bond as an amortized asset is an accounting method used by companies that issue bonds. It allows issuers to treat the bond discount as an asset over the life of the bond until its maturity date. A bond is sold at a discount when a company sells it for less than its face value and sold at a premium when the price received is greater than face value.

If a bond is issued at a discount—that is, offered for sale below its par or face value—the discount must be treated either as an expense or it can be amortized as an asset. In this way, an amortized bond is used specifically for tax purposes because the amortized bond discount is treated as part of a company’s interest expense on its income statement. The interest expense, a non-operating cost, reduces a company’s earnings before tax (EBT) and, therefore, the amount of its tax burden.

Effective-interest and straight-line amortization are the two options for amortizing bond premiums or discounts. The easiest way to account for an amortized bond is to use the straight-line method of amortization. Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond.

Companies may also issue amortized bonds and use the effective-interest method. Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period. Under this second type of accounting, the bond discount amortized is based on the difference between the bond’s interest income and its interest payable. Effective-interest method requires a financial calculator or spreadsheet software to derive.

What Is Actuarial Science?

Actuarial science is a discipline that assesses financial risks in the insurance and finance fields, using mathematical and statistical methods. Actuarial science applies the mathematics of probability and statistics to define, analyze, and solve the financial implications of uncertain future events. Traditional actuarial science largely revolves around the analysis of mortality and the production of life tables, and the application of compound interest.

Understanding Actuarial Science

Actuarial science attempts to quantify the risk of an event occurring using probability analysis so that its financial impact can be determined. Actuarial science is typically used in the insurance industry by actuaries. Actuaries analyze mathematical models to predict or forecast the reasonableness of an event occurring so that an insurance company can allocate funds to pay out any claims that might result from the event. For example, studying mortality rates of individuals of a certain age would help insurance companies understand the likelihood or timeframe of paying out a life insurance policy.

Actuarial science became a formal mathematical discipline in the late 17th century with the increased demand for long-term insurance coverage. Actuarial science spans several interrelated subjects, including mathematics, probability theory, statistics, finance, economics, and computer science. Historically, actuarial science used deterministic models in the construction of tables and premiums. In the last 30 years, science has undergone revolutionary changes due to the proliferation of high-speed computers and the union of stochastic actuarial models with modern financial theory.

Applications of Actuarial Science

Life insurance and pension plans are the two main applications of actuarial science. However, actuarial science is also applied in the study of financial organizations to analyze their liabilities and improve financial decision-making. Actuaries employ this specialty science to evaluate the financial, economic, and other business applications of future events.

Insurance

In traditional life insurance, actuarial science focuses on the analysis of mortality, the production of life tables, and the application of compound interest, which is the accumulated interest from previous periods plus the interest on the principal investment. As a result, actuarial science can help develop policies for financial products such as annuities, which are investments that pay a fixed income stream. Actuarial science is also used to determine the various financial outcomes for investable assets held by non-profit corporations as a result of endowments. 

In health insurance, including employer-provided plans and social insurance, actuarial science includes analyzing rates of

• Disability in the population or the risk of a certain group of people becoming disabled
• Morbidity or the frequency and the extent to which a disease occurs in a population
• Mortality or mortality rate, which measures the number of deaths in a population that result from a specific disease or event
• Fertility or fertility rate, which measures the number of children born

For example, disability rates are determined for veterans that may have been wounded in the line of duty. Certain percentages are assigned to the extent of the disability to determine the payout from disability insurance.

Actuarial science is also applied to property, casualty, liability, and general insurance–instances in which coverage is generally provided on a renewable period, (such as yearly). Coverage can be canceled at the end of the period by either party.

Pensions

In the pension industry, actuarial science compares the costs of alternative strategies with regard to the design, funding, accounting, administration, and maintenance or redesign of pension plans. A pension plan is a defined-benefit plan, which is a type of retirement plan involving contributions from the employer to be set aside and paid out to the employees upon retirement.

Short-term and long-term bond rates greatly influence pension plans and their investment strategies. Bonds are debt instruments issued by governments and corporations that typically pay a periodic interest rate. For example, in a low-interest-rate environment, a pension plan might have difficulty earning income from the bonds that it has invested in, which increases the probability that the pension plan could run out of money.

Other factors impacting a pension plan’s viability include benefit arrangements, collective bargaining, the employer’s competitors, and changing demographics of the workforce. Tax laws and the policies of the Internal Revenue Service (IRS) regarding the calculation of pension surpluses also impact the finances of a pension plan. Additionally, economic conditions and trends in the financial markets can impact the probability of a pension plan remaining funded.

Universities and Professional Certifications

According to the Bureau of Labor Statistics, the number of actuaries employed is expected to grow 21% from 2021 to 2031. For this reason, many universities offer educational degrees and courses on actuarial science. In addition, there are professional designations for those interested in pursuing the field.

Universities

The Society of Actuaries identifies and reports colleges that meet one of three levels of recognition:

• UCAP-Introduction Curriculum: Universities that maintain course requirements for two professional actuarial exams in addition to having met other approved course requirements.
• UCAP-Advanced Curriculum: Universities that maintain course requirements for four professional exams in addition to having met other approved course requirements.
• Center of Actuarial Excellence: Universities that maintain eight specific requirements in connection with a variety of matters. This is the highest tier of competency identified by the SOA for a university.

As of December 2022, there are roughly 25 Center of Actuarial Excellence schools across the United States, Canda, Australia, Singapore, the United Kingdom, and China. Within the U.S., these schools include but are not limited to Brigham Young, Georgia State, Purdue, Connecticut, and Michigan.

Professional Designations and Credentials

There are a number of different professional designations an actuary can pursue to further gain credibility and proficiency in their field. The Casualty Actuarial Society offers the Associate (ACAS) and Fellow (FCAS) membership levels, each of the two with escalating requirements. For example, the ACAS credential can be achieved after passing six exams, while the FCAS is earned after nine exams. Areas of focus for the FCAS exam include:

• Probability
• Financial Mathematics
• Financial Economics
• Modern Actuarial Statistics
• Basic Techniques for Ratemaking and Estimating Claim Liabilities
• Regulation & Financial Reporting
• Policy Liabilities, Insurance Company Valuation, and Enterprise Risk Management
• Advanced Ratemaking

The Society of Actuaries promotes several different actuarial exams to demonstrate competency in the field.

• An Associate of the Society of Actuaries (ASA) demonstrates knowledge of fundamental concepts of modeling and managing risk. The examination requirements are changing as of Spring 2023, and the list of required examinations includes topics on predictive analysis, economics, probabilities, and financial markets.
• A Chartered Enterprise Risk Analyst (CERA) specializes in having knowledge in identifying, measuring, and managing risk in risk-bearing enterprises. Similar to the ASA requirements, the CERA requirements include a professional course covering code of conduct.
• A Fellow of the Society of Actuaries (FSA) demonstrates knowledge of financial decisions involving pensions, life insurance, health insurance, and investments. FSAs also must demonstrate in-depth knowledge and the application of appropriate techniques to these various areas.

The Bottom Line

Actuarial science is the study of mathematically predicting the probability of something happening in the future and assigning that outcome a financial value. Companies, pension funds, and insurance agencies rely on actuaries to develop models to assess areas of risk and devise policies to mitigate potential future challenges.

What Is at Par?

The term “at par” means at face value. A bond, preferred stock, or other debt instrument may trade at par, below par, or above par.

Par value is static, unlike market value, which fluctuates with credit ratings, time to maturity, and interest rate fluctuations. The par value is assigned at the time the security is issued. When securities were issued in paper form, the par value was printed on the face of the security, hence the term “face value.”

Understanding at Par

Due to the constant fluctuations of interest rates, bonds and other financial instruments almost never trade exactly at par. A bond will not trade at par if current interest rates are above or below the bond’s coupon rate, which is the interest rate that it yields.

A bond that was trading at par would be quoted at 100, meaning that it traded at 100% of its par value. A quote of 99 would mean that it is trading at 99% of its face value.

Par value for common stock exists in an anachronistic form. In its charter, the company promises not to sell its stock at lower than par value. The shares are then issued with a par value of one penny. This has no effect on the stock’s actual value in the markets.

A New Bond

If, when a company issues a new bond, it receives the face value of the security, the bond is said to have been issued at par. If the issuer receives less than the face value for the security, it is issued at a discount. If the issuer receives more than the face value for the security, it is issued at a premium.

The yield for bonds and the dividend rate for preferred stocks have a material effect on whether new issues of these securities are issued at par, at a discount, or at a premium.

A bond that trades at par has a yield equal to its coupon. Investors expect a return equal to the coupon for the risk of lending to the bond issuer.

Example of at Par

If a company issues a bond with a 5% coupon, but prevailing yields for similar bonds are 10%, investors will pay less than par for the bond to compensate for the difference in rates. The bond’s value at its maturity plus its yield up to that time must be at least 10% to attract a buyer.

If prevailing yields are lower, say 3%, an investor is willing to pay more than par for that 5% bond. The investor will receive the coupon but have to pay more for it due to the lower prevailing yields.

What Is an Asset Class?

An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Asset classes are thus made up of instruments that often behave similarly to one another in the marketplace.

Understanding Asset Classes

Simply put, an asset class is a grouping of comparable financial securities. For example, IBM, MSFT, AAPL are a grouping of stocks. Asset classes and asset class categories are often mixed together. There is usually very little correlation and in some cases a negative correlation, between different asset classes. This characteristic is integral to the field of investing.

Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or money market instruments. Currently, most investment professionals include real estate, commodities, futures, other financial derivatives, and even cryptocurrencies in the asset class mix. Investment assets include both tangible and intangible instruments which investors buy and sell for the purposes of generating additional income, on either a short- or a long-term basis.

Financial advisors view investment vehicles as asset class categories that are used for diversification purposes. Each asset class is expected to reflect different risk and return investment characteristics and perform differently in any given market environment. Investors interested in maximizing return often do so by reducing portfolio risk through asset class diversification.

Financial advisors will help investors diversify their portfolios by combing assets from different asset classes that have different cash flows streams and varying degrees of risk. Investing in several different asset classes ensures a certain amount of diversity in investment selections. Diversification reduces risk and increases your probability of making a return.

Asset Class and Investing Strategy

Investors looking for alpha employ investment strategies focused on achieving alpha returns. Investment strategies can be tied to growth, value, income, or a variety of other factors that help to identify and categorize investment options according to a specific set of criteria. Some analysts link criteria to performance and/or valuation metrics such as earnings-per-share growth (EPS) or the price-to-earnings (P/E) ratio. Other analysts are less concerned with performance and more concerned with the asset type or class. An investment in a particular asset class is an investment in an asset that exhibits a certain set of characteristics. As a result, investments in the same asset class tend to have similar cash flows.

Asset Class Types

Equities (stocks), bonds (fixed-income securities), cash or marketable securities, and commodities are the most liquid asset classes and, therefore, the most quoted asset classes.

There are also alternative asset classes, such as real estate, and valuable inventory, such as artwork, stamps, and other tradable collectibles. Some analysts also refer to an investment in hedge funds, venture capital, crowdsourcing, or cryptocurrencies as examples of alternative investments. That said, an asset’s illiquidity does not speak to its return potential; It only means it may take more time to find a buyer to convert the asset to cash.