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.

  1. Accrual Rate

    Accrual rate refers to the rate of interest that is added to ...
  2. Constant Yield Method

    The constant yield method is one way of calculating the accrued ...
  3. Principal

    Principal is the amount borrowed on a loan or put into an investment.
  4. Zero-Coupon Mortgage

    A zero coupon mortgage is a long-term commercial mortgage that ...
  5. Bond Valuation

    Bond valuation is a technique for determining the theoretical ...
  6. And Interest

    And interest is a slang phrase used when quoting the price of ...
Related Articles
  1. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  2. Investing

    Savings Bonds For Income And Safety

    Bonds offer undeniable benefits to investors, including safety and tax advantages.
  3. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  4. Investing

    4 basic things to know about bonds

    Learn the basic lingo of bonds to unveil familiar market dynamics and open to the door to becoming a competent bond investor.
  5. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  6. Investing

    How Rising Interest Rates Impact Bond Portfolios

    A look at the impact that changing interest rates - rising or falling - have on bonds and what investors need to consider.
  7. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
  1. What is accrued interest, and why do I have to pay it when I buy a bond?

    An investor who sells a bond must be compensated in coupon payments for the period they owned the bond, defined as the interest ... Read Answer >>
  2. What are the risks of investing in a bond?

    Are you thinking of investing in bond market? Learn more about bond market investment risk, including interest rate risk, ... Read Answer >>
  3. Which factors most influence fixed-income securities?

    Learn about the main factors that impact the price of fixed-income securities, and understand the various types of risk associated ... Read Answer >>
Trading Center