What Is a Deferred Interest Bond?
A deferred interest bond, also called a deferred coupon bond, is a debt instrument that pays all of its interest that has accrued in the form of a single payment made at a later date rather than in periodic increments.
- Deferred interest bonds pay their accrued interest as a lump-sum amount at a later date rather than as periodic coupons.
- Zero-coupon bonds and toggles note are two types of deferred interest bonds.
- A deferred interest bond can be a good choice for investors seeking a higher rate of interest than a normal savings account, but investors looking for periodic investment income may not find these bonds to their liking.
Understanding Deferred Interest Bond
A conventional bond pays interest periodically to investors until the bond matures, at which point, investors are repaid the principal amount. Certain types of bonds don’t pay interest; instead, the interest that accrues over the life of the bond is paid out when the bond matures in addition to the principal. Such bonds are referred to as deferred interest bonds. For example, a one-year deferred interest bond with a par value of $1,000 and an annual yield of 8% would pay the investor $80 interest + $1,000 initial investment for a total sum of $1,080 when the bond matures.
Most deferred interest bonds pay the accrued interest in full only upon maturity. These bonds are initially offered at a deep discount to entice potential bondholders to buy these even though they know that the normal periodic interest payments will not be forthcoming.
A common form of deferred interest bond is one that does not make interest payments until a certain period has passed. At the end of the deferred-interest period, the bond begins to pay interest on a periodical basis until maturity date or call date. For example, a bond with maturity date of 10 years has a provision in its trust indenture that coupon payments are to start four years after issuance. In this case, this bond has a zero-coupon for the first four years, and then a fixed coupon for the remaining six years.
A deferred interest bond can be a good choice for those looking to save money while accruing more interest than they might receive in a bank savings account or a money market fund. Conversely, investors looking for periodic income may not find these bonds an attractive investment for their portfolios.
A common type of a deferred interest bond is a zero-coupon bond (z-bond), which pays no interest at all but offers appreciation in bond value through the par value. The difference between the purchase price and face value repaid at maturity is the interest earned on the bond for the investor. Since there are no payments prior to maturity, zero-coupons have no reinvestment risk. Zero-coupon bonds do not technically pay any interest, but are instead sold at a discount, maturing to face value.
Example: Toggle Notes
Another type of a deferred interest bond is a toggle note which can be used by issuing firms with temporary cash flow to raise debt while staying afloat during times of strained cash flow without defaulting. A toggle note is a loan agreement that allows a borrower to defer an interest payment by agreeing to pay an increased coupon in the future. Interest will, in effect, be paid for by incurring additional debt, often at a higher rate of interest. For example, if a company chooses to defer paying interest until the bond matures, its interest on the debt may increase from 7.8% to 9.1%.