Balloon Maturity Definition
Balloon maturity means that the principal or face value of a debt instrument is due in a single, lump-sum payment at the end of a stated period.
This term is mostly used in bond issuing. It is also quite risky planning for balloon maturity and issuing bonds. The issuer must be able to meet the demands of the bonds issued and other payments. For example, if a bank decides to issue a bond in a year that will mature in 10 years, it must be able to pay the principal of the bonds when due and also meet the coupon payments for a period of ten years.
A Little More on What is Balloon Maturity
Another way to avoid the risk of balloon maturity is by issuing serial bonds. Serial bonds are paid at regular intervals unlike being paid in total at a particular point in time. They are used to fund substantial projects that lasts for several years. Serial bonds mature gradually over a time frame.
For instance, an issuer can prevent paying a huge sum when releasing 500 bonds that has matured gradually for a period of 5 years. Serial bonds allows for a monthly payment rather than paying an exorbitant fee of balloon maturity.
Balloon Maturity in Mortgages
Balloon maturity is basically derived from bond transactions, but recently used to refer to a final large sum of money in a debt repayment plan processed at a specific time. This repayment could be on mortgages, commercial loans and other debts. When a balloon maturity is used in a mortgage, there will other smaller payment followed by a huge sum of balloon payment. This balloon payment is usually the last payment.
An increased balloon payment indicates that while other smaller payments has been done, the debt has not been amortized. The process of amortization involves creating a plan of regular payments of both interest and principal. Most payment made goes to reducing the principal but early payment reduces the interest paid and also the principal amount paid.
A repayment schedule or plan can benefit a company that has shown high tendency to grow within the next 10 or 15 years the loan term will expire. At that point in time, the company should have enough profit to cover the balloon payment.
Asides company whose profit is low and will be needing a loan, individuals too might choose to go for a home mortgage as a result of low income. This individual might have anticipated a large sum of income in the future, an inheritance or property sale which would allow for the balloon payment when due. inability to pay the balloon payment will require a financing the mortgage again or selling the acquired property.
Reference for “Balloon Maturity”
Academic research on “Balloon Maturity”
Shareholder gains from callable‐bond refundings, Emery, D. R., & Lewellen, W. G. (1990). Shareholder gains from callable‐bond refundings. Managerial and Decision Economics, 11(1), 57-63. A re‐examination indicates that current procedures for measuring the benefit realized by shareholders when a firm calls and refunds an outstanding debt obligation are mis‐specified. The key to a proper measurement is found to lie in the identification of the extinguished remaining‐time‐to‐maturity value of the exercised option on the called debt. A simple procedure for assessing that value is provided and incorporated into a corrected measure of the gains from a callable‐bond refunding.
Optimal bond refunding strategies, Lewellen, W. G., & Rosenfeld, A. (1987). Optimal bond refunding strategies. Managerial and Decision Economics, 8(3), 243-250. An extension of the conceptual framework for assessing the desirability of a bond refunding operation is presented. The analysis indicates an expanded set of opportunities for enhancing shareholder wealth that may involve actions other than an immediate call of existing debt, even though the latter appears worthwhile. Conditions that specify the optimal timing of a call are derived.
Foreclosure of Securitized Commercial Mortgages—A Model of the Special Servicer, Liu, P., & Quan, D. (2013). Foreclosure of Securitized Commercial Mortgages—A Model of the Special Servicer. The Journal of Real Estate Finance and Economics, 46(2), 321-338. The decision to foreclose on a CMBS mortgage is made by the special servicer. A mortgage loan is in special servicing when it is either delinquent or in a state of imminent default. A special servicer should represent the interests of the underlying CMBS bondholders by returning the highest possible value to the investors. In this paper, we show that a special servicer’s compensation structure results in an incentive for her to extend a loan beyond the time desired by its bondholders. We develop a model and demonstrate how compensation incentives interact and influence a special servicer’s foreclosure decisions. Our model takes into consideration the dynamic nature of such a decision by viewing is as a dynamic programming problem whereby foreclosure represents a discrete terminal state of an optimal stopping problem. This model thus captures the trade-off between continuation of a loan and termination and we use this model to determine how the stopping rule changes under various compensation structures.
Credit risk findings for commercial real estate loans using the reduced form, Christopoulos, A. D., & Barratt, J. G. (2016). Credit risk findings for commercial real estate loans using the reduced form. Finance Research Letters, 19, 228-234. This paper considers probability of default and expected loss profiles of 25,019 mortgages collateralized by commercial real estate properties evaluated using a reduced form model on a daily basis over the period November 2007 through January 2015. Our evaluations provide a compact and valuable set of insights to build intuition on credit risks facing CMBS investors.