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.

RELATED TERMS
  1. Constant Yield Method

    The constant yield method is one way of calculating the accrued ...
  2. Deferred Interest Bond

    Deferred interest bond is a debt instrument that pays interest ...
  3. Straight Bond

    A straight bond is a bond that pays interest at regular intervals, ...
  4. Zero-Coupon Bond

    A zero-coupon bond is a debt security that doesn't pay interest ...
  5. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  6. Bond Valuation

    Bond valuation is a technique for determining the theoretical ...
Related Articles
  1. Investing

    Savings Bonds For Income And Safety

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

    Corporate Bond Basics: Learn to Invest

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

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  4. Financial Advisor

    Calculate PV of different bond type with Excel

    To determine the value of a bond today — for a fixed principal (par value) to be repaid in the future — we can use an Excel spreadsheet.
  5. 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.
  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

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
RELATED FAQS
  1. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... 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 >>
  4. What determines bond prices on the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market and why bond prices and yields ... Read Answer >>
Hot Definitions
  1. Risk Tolerance

    Risk tolerance is the degree of variability in investment returns that an individual is willing to withstand.
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Initial Coin Offering (ICO)

    An Initial Coin Offering (ICO) is an unregulated means by which funds are raised for a new cryptocurrency venture.
  4. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  5. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  6. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
Trading Center