DEFINITION of Accrual Bond
An accrual bond is a bond that does not pay periodic interest to bondholders. Instead, interest is added to the principal balance of the bond and is either paid at maturity or, at some point, the bond begins to pay both principal and interest based on the accrued principal and interest to that point.
BREAKING DOWN Accrual Bond
A traditional bond involves making periodic interest payments to bondholders in the form of coupons. The interest is paid at scheduled dates until the bond expires, at which point, the principal investment is repaid to the bondholders. However, not all bonds make scheduled coupon payments. One such bond is the accrual bond.
An accrual bond defers interest until the bond matures. This means interest is added to the principal and additional interest is calculated over the growing principal. In other words, the interest due to the accrual bond in each period accretes and is added to the existing principal balance of the bond due for payment at a later date. An accrual bond is typically issued with a long-term maturity (20 to 25 years) by corporate entities. It is sold at a deep discount to the face value; the discount value represents the interest earned on the bond. Although interest is not paid throughout the bond’s life, the Internal Revenue Service (IRS) still requires accrual bondholders to report the imputed interest on the bond as interest income for tax purposes.
The interest does not necessarily have to be paid at maturity. It could also be paid at some point after the interest has accrued up to a certain level. When the bond begins to pay both principal and interest based on the accrued principal and interest at that point, this is known as a Z tranche and is common in collateralized mortgage obligations (CMOs). In a CMO that includes a Z tranche, the interest payments that otherwise would be paid to the Z-tranche holder are used to pay down the principal of another tranche. After that tranche is paid off, the Z tranche begins to pay down based on the original principal of the tranche plus the accrued interest.
In contrast to a zero-coupon bond, an accrual bond has a clearly stated coupon rate. Similar to a zero-coupon bond, an accrual bond or Z tranche has limited to no reinvestment risk. This is because the interest payment made to bondholders is delayed. However, accrual bonds, by definition, have a longer duration than bonds with the same maturity that make regular interest or principal and interest payments. As such, accrual bonds are subject to greater interest rate risk than bonds that make periodic payments over their entire terms.