Bullet Repayment: a Worked Example

Every instalment on an amortising loan is a small test the borrower passes and a small reduction in what the lender can lose. A bullet gives up both. The lender's exposure on the last day is what it was on the first, and the first real test of repayment capacity comes when the whole amount is due.

Lenders accept that where the source of repayment is credible without instalments. A property investor may be able to sell or refinance a let building. A large corporate borrower may have ready access to banks and bond investors. Institutional term loans are typically repaid almost entirely at maturity. A bridging loan is repaid in one amount from a named event. Where none of those applies, a bullet relies on a future lender no one has met.

Because there is no principal in the schedule, debt service is interest alone for the whole term, so debt service cover adds little to interest cover. A cover figure on a bullet says the business can afford the interest and is silent on the debt. It can also cost some banks more capital. Under the Basel rules for banks on the advanced internal-ratings approach, effective maturity is weighted by the cash-flow schedule, between a floor of one year and a cap of five, so a loan paying only interest until year five counts as longer than one repaying through the term. The foundation approach uses a fixed figure, and national rules vary.

The owner of a student-accommodation building, constructed for this page like every figure in it, borrows US$30m for five years at a fixed 6.5%, with interest paid annually for simplicity. The building is worth US$60m and earns net income of US$3.6m. The bank compares a bullet with repaying US$0.6m a year.

The bullet asks less of the year's cash and shows better cover, for US$0.39m more interest over the term. The line that decides the file is the last. To test it, the bank asks what another lender would advance in five years, using a limit of 55% of value and interest cover of 1.75 times. Those limits and the market cases are the example's, not a market norm.

In the plan case, either structure refinances. In the weaker case, nothing in the building has changed except its market, and the bullet leaves a gap of nearly a fifth of the loan. Cover decides that result, not value, which is why a bank looking only at the loan-to-value ratio would have missed the size of it. Repayment of US$0.6m a year would have more than halved the gap, at a cost of US$0.6m a year in cash the owner could otherwise have distributed.

The structures sit along one line, measured by how much of the debt is still owing when the term ends. Full instalments finish at nothing. A balloon finishes somewhere between: with this page's loan, perhaps US$12m after five years of larger payments. A bullet finishes at US$30m. Lenders and websites do not use the words consistently, so the schedule in the agreement matters more than its label.

An interest-only period is closely related. A loan interest-only for its whole life is a bullet; one interest-only for its first two years is not. What the lender is testing differs too: the step-up to instalments in one case and refinancing risk in the other.

DEFINED IN ONE PARAGRAPH → · BALLOON PAYMENT, WORKED → · REFINANCING RISK →

The first decision is the structure itself. Asked for a bullet by a borrower it reads less warmly, a lender can offer instalments, a small annual repayment, or a cash sweep that takes part of any surplus. Since exposure does not fall on its own, the covenants carry more of the load: loan-to-value, interest cover and limits on distributions.

The second is the calendar. A borrower with two bullets falling in one year has concentrated its refinancing into one market. Any interest-rate hedge will often need a decision around the same date. And the debt moves into current liabilities once the borrower has no right to defer it for at least twelve months after balance date, under the international standard used in New Zealand and Australia and under FRS 102 in the UK, so the last set of accounts before maturity reads as if the business is short of liquidity. A refinancing begun then has started late, and the six months before maturity set out what the desk is doing meanwhile.