Deferred Interest Bond

Deferred Interest Bond

A deferred interest bond is a type of debt security that accumulates interest, which is not paid out periodically but instead is deferred until the bond matures. This means investors do not receive regular interest payments (coupons) as they might with standard bonds. Instead, all accrued interest, along with the principal, is paid in a lump sum at the bond’s maturity date.

Examples of Deferred Interest Bonds

1. Zero Coupon Bond: One of the most common examples of a deferred interest bond. Zero coupon bonds do not make periodic interest payments. Instead, they are sold at a discount to their face value and pay the face value at maturity, with the difference representing the accrued interest.

2. Capital Appreciation Bonds (CABs): These are municipal securities issued at a discount to face value and do not make periodic interest payments. Interest accrues and is compounded over the life of the bond and is paid along with the principal at maturity.

Frequently Asked Questions (FAQs)

Q1: Why would an investor choose a deferred interest bond?

• A1: Investors might choose deferred interest bonds for various reasons, including the ability to lock in a fixed rate of return that compounds over time, potentially higher total returns due to reinvested interest, and possibly favorable tax treatments, as interest accrual is often deferred.

Q2: Are deferred interest bonds riskier than regular bonds?

• A2: Deferred interest bonds come with specific risks, such as reinvestment risk, interest rate risk, and credit risk. Additionally, they carry the risk that the lump-sum payment at maturity may not be received if the issuer defaults.

Q3: How is interest on deferred interest bonds taxed?

• A3: The tax treatment can vary. For example, in the case of zero coupon bonds, investors are usually required to pay taxes on the accrued interest as it accrues, even though it is not received until maturity (known as phantom income).

Q4: How does a deferred interest bond differ from a regular coupon bond?

• A4: Unlike regular coupon bonds which pay interest periodically (e.g., semi-annually or annually), deferred interest bonds accumulate interest, which is paid out in a single lump sum at maturity.

Q5: Can deferred interest bonds be traded on secondary markets?

• A5: Yes, deferred interest bonds can be traded on secondary markets. However, their market price will fluctuate based on prevailing interest rates and the time remaining to maturity.

Related Terms with Definitions

• Zero Coupon Bond: A bond that is sold at a discount and does not pay any interest payments during its life. All interest is paid at maturity along with the principal.
• Yield to Maturity (YTM): The total return expected on a bond if it is held until maturity. This yield accounts for the bond’s current market price, par value, coupon interest rate, and time to maturity.
• Duration: A measure of the sensitivity of the price of a bond to a change in interest rates, typically expressed in years.
• Phantom Income: Income that must be reported for tax purposes despite not receiving the actual cash. This commonly applies to zero coupon bonds where the interest accrues annually but is paid at maturity.

Online References

• Investopedia: Zero-Coupon Bonds
• FINRA: Types of Bonds
• TreasuryDirect: Nonmarketable Bonds

Suggested Books for Further Studies

1. “The Bond Book” by Annette Thau: A comprehensive guide to various types of bonds and fixed income investments.
2. “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman: An in-depth look at fixed income markets and their instruments.
3. “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi: A detailed exploration of bond markets and investment strategies.

Fundamentals of Deferred Interest Bonds: Finance Basics Quiz

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