What is an Accumulation Bond
An accumulation bond is one sold at a discount, known as an original issue discount (OID). An OID is a discount from par value at the time a bond or debt instrument is issued. In other words, the bondholder, or lender, is merely giving the issuing company less money than it has legally borrowed. In exchange, the lender will forgo the interest income since the bond issuer is not required to make interest payments, as is typically done.
An accumulation bond is so named because the value of the bond accumulates over time. They are also known as zero-coupon discount bonds.
BREAKING DOWN Accumulation Bond
An accumulation bond sells at an original issue par value with a discount. Par value is the face value of a bond and accumulation bonds always sell below this face value. Some investors like to use accumulation bonds in their financial plans, as they know the exact amount they will receive at a future point when the bond matures.
Federal, local, or state government agencies often issue accumulation bonds.
Tax Implications of Accumulation Bonds
Even though the bondholder is not receiving coupon payments, the interest on the bond still accumulates and must be reported as interest income on the bondholder's tax return each year. This is sometimes referred to as phantom income. Also, the Internal Revenue Service considers an original issue discount (OID) a form of interest.
Investors in accumulation bonds should be aware, however, that accumulation bonds are at risk of suffering steep price declines during times of rising interest rates.
Example of an Accumulation Bond
The Widget Group needs to build a new widget factory. They also need some extra money to refurbish its offices. The factory will cost $710,000, while the refurbishment will cost $33,000.
The executives of The Widget Group decide to sell an accumulation bond to finance these expenditures, promising to repay its lenders to $1 million in 15 years. But because this is an accumulation bond, The Widget Group will pay no interest on the loan.
Instead, the company will not receive the entire $1 million up front, but a discounted $743,000, which is enough to meet its new expenses. The difference of $257,000, or what the lender did not have to lend, makes up for the lack of interest income.
In this hypothetical example, the bond’s interest rate would amount to approximately 2%. The bondholder, however, would not recognize this income all at once, either at the beginning or the end of the bond’s maturity. That’s because the IRS’s sees this income as being accumulated over time.