DEFINITION of Deferred Interest Bond
Deferred interest bond is a debt instrument that pays interest in full only upon maturity. Unlike most bonds, a deferred interest bond does not make periodic coupon payments over its lifetime.
Deferred interest bond is also called deferred coupon bond.
BREAKING DOWN 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 bond. For example, a one-year deferred interest bond with a par value of $1,000 and an annual yield of 6% would pay the investor $60 interest + $1,000 initial investment = $1,060 when the year is up.
An examples of a deferred interest bonds is a zero-coupon 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. Because there are no payments prior to maturity, zero-coupons have no reinvestment risk. Zero-coupon bonds are sold at a discount.
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%.
Another form of deferred interest 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. Investors looking for interest income may not find these bonds an attractive investment for their portfolios. Deferred interest bonds are typically issued at a deep discount to compensate bondholders for the period of non-interest payments.