Accrual Bonds: Definition, Mechanics, Risks, and Taxation

Accrual bonds represent a distinct approach to interest payments compared to traditional bonds. Unlike conventional bonds, which distribute periodic interest, accrual bonds postpone interest payments, typically until maturity. Instead of receiving interest in installments, the interest accumulates and is appended to the principal balance of the bond. This results in subsequent interest calculations being based on the augmented principal, ultimately leading to a larger payout at maturity or a predetermined date.

Accrual bonds adhere to a fixed coupon rate similar to traditional bonds. However, unlike traditional bonds that disburse periodic interest, accrual bonds do not provide interest payments to bondholders during the bond’s lifespan. Instead, the interest accrues and augments the principal balance, thereby augmenting the eventual payout at maturity.

Accrual bonds are typically sold at a considerable discount to their face value, reflecting the interest that will accumulate over time. This discounted price enables investors to purchase accrual bonds at a lower rate than their anticipated payout, potentially resulting in capital appreciation. Moreover, accrual bonds often boast long-term maturities, ranging from 20 to 25 years.

While accrual bonds share similarities with zero-coupon bonds by deferring interest payments, they differ significantly in one aspect: accrual bonds possess a fixed coupon rate. This feature distinguishes accrual bonds from zero-coupon bonds, which lack a specified coupon rate.

Accrual bonds, despite offering the potential for capital appreciation and having limited reinvestment risk, are susceptible to greater interest rate risk than bonds with regular interest payments. This heightened risk arises from the prolonged duration of accrual bonds compared to bonds with the same maturity that provide periodic interest payments.

Accrual bonds require holders to report interest income for tax purposes, even if the interest is not received until maturity. This means that investors may be liable for taxes on accrued interest income.

Accrual bonds are commonly issued with long-term maturities ranging from 20 to 25 years, providing investors with extended investment horizons.

Accrual bonds typically entail limited reinvestment risk since interest payments are deferred. However, they remain subject to interest rate risk due to their extended duration.