Bonds and Balloon Interest

Balloon interest is an informal term used to describe the payment model on certain long-term bond options. These serial bonds have multiple coupon rates as they mature. Simply put, these are long-term bonds with several different rates throughout the length of time it takes them to matures. The investor is rewarded for holding onto the bond for the full-length of time through increasing rates as the bond grows older.

Balloon Interest Bond Example

Serial bonds are issued for projects that are expected to generate increased earnings the longer they are in effect. For example, in the first few years of a water dam project, the project will be in the red, meaning it is losing money. After that, the project will begin to generate profits. Eventually, as more and more customers begin to receive energy from the water power dam, the dam begins to earn money, creeping into the black and eventually increasing profits substantially. An investor in one of these projects may be offered a serial bond with a balloon interest rate. While the project is still in the red, the interest rate would be incredibly low. If the investor holds the bond to maturity, though, the investor would begin to see his or her profits grow annually just like the profits from the dam.

Advantages of Balloon Interest Bonds

Balloon interest bonds offer protection against inflation over time. One problem presented with a traditional long-term bond is the likelihood inflation will increase over time, taking a bite out of your potential profits. Long-term bonds attempt to compensate for this challenge by offering higher interest rates than their short-term counterparts. However, sometimes these higher interest rates will still not be enough to help you generate a sufficient profit. Balloon interest bonds typically at least keep pace with inflation and often outpace inflation.

Disadvantages of Balloon Interest Bonds

The goal with a balloon interest bond is to have the profitability of the project capping out just about the time the bond matures. If you succeed in this goal, your bond's interest will grow with the underlying asset, and the bond will expire just as that asset begins to flat-line. Unfortunately, it is very hard to anticipate when an investment will flat-line from a distant point in the past. As a result, many investors fail to completely capitalize on the profitability of a given project. It may be wiser to purchase several short-term bonds in the project as it grows. That way, you have the option of exiting sooner, but you can still capitalize on increasing interest rates.

Buying Balloon Interest Bonds

Look for bonds focusing on infrastructure development or private projects if you would like to seek out balloon interest rates. Renewable energy bonds and green technology bonds are popular models within the balloon interest industry in the 21st century. Some advisers believe the highest potential for profits in bonds in the new economy following the 2007 market collapse will be in education, energy and health care. Each of these industries is experiencing substantial government assistance as of 2010, providing new opportunities for balloon interest bonds.

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