What is Balloon Interest?

Balloon interest is the amount of interest that is earned on bonds that are structured with longer maturity periods. Interest of this type is often associated with serial bonds, which usually are created with an extended life and may not pay any type of return until well into the life of the bond, or even until full maturity is reached. Generally, bonds structured to pay balloon interest offer a higher rate of interest, owing to the fact that the investor must wait additional time to realize a return.

There are several benefits associated with balloon interest. The fact that the rate of interest is higher than on similar bonds with a shorter duration is one of the main attractions. Assuming that the investor can afford to wait a longer period for the interest payments to begin, this means that more income is generated from the investment than would be possible with similar bond issues that have a shorter life.

For entities that issue bonds with balloon interest, the approach allows more time for the project to begin generating revenue that can be used to cover the interest payments back to investors. Municipalities may use this model for a bond issue associated with some type of civic improvement where revenues from taxes, tolls, or other means of generating ongoing revenue are involved. Since the payment of interest is delayed, there is more time for these income generation capabilities to begin, and allow the issuer to have no trouble at all in paying the balloon interest on time.

The underlying factor that leads to the offering of balloon interest has to do with time. Serial bonds, and other types of extended bond issues, are helpful when there is some concern about exactly when the project will begin to generate funds that can be used to pay investors. By going with a longer duration of the bond, and possibly structuring the bond so that payment of the interest is delayed, the chance of getting into a financial bind before the project becomes self-supporting is minimized.

Bonds that are structured with balloon interest are not for everyone. If the issuer plans on seeing a quick return from the project underwritten with the proceeds from the bond sale, then committing to the higher rate of interest with the balloon approach may not be in the best interests of the project. At the same time, investors who need a relatively short turnaround on earning a return would do well to go with bond issues that have a shorter duration, even though the rate of return may be smaller.