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In the fixed income markets, there are a variety of
instruments that defer the payment of interest. This article focuses on
instruments that have terms
greater than a year. See the article
discount instruments for the shorter-term forms.
Generally, the instruments are called
deferred-interest bonds (DIBs).
They fall into three categories.
 Accrued-coupon
bonds are issued at some par
value and have a stated nominal yield.
Rather than pay coupons, they
accrue them until maturity.
Zero-coupon
bonds have a par value that is their maturity value.
They are issued at a discount from that par value. These are also called
zeros or
original issue discount (OID) bonds.
Deferred-coupon
bonds (or split-coupon bonds) pay no coupons for their first few years but then pay a
higher coupon than they otherwise would for the remainder of their term.
Usually, they are issued below par. If the
issuer's credit quality doesn't deteriorate and interest rates don't rise,
they trade above par by the time
they start paying coupons. They mature for their par value plus the final
coupon.
The instruments generally have terms of ten years or more.
If they are issued with shorter terms, they may be called
notes instead of
bonds. All three structures are illustrated in Exhibit 1.
While accrued-coupon and zero-coupon bonds only pay interest at
maturity, for accounting and tax purposes, interest is generally
recognized as income when it accrues. Treatment of deferred-coupon bonds
depends upon the specific structure and jurisdiction.
Paradoxically, you will hear of accrued-coupon and
zero-coupon bonds being described as either safe, conservative investments
or risky, speculative investments. It
all depends on how you intend to use and account for them. For a
buy-and-hold investor who accounts for them at
book value, the bonds can be a safe
investment, so long as the issuer is of good credit quality.
They guarantee a specific yield until
maturity. Because they don't pay coupons, they pose no
reinvestment risk. On the other hand,
for
investors who may sell the bonds prior to maturity or account for them at
market value, they can be quite
risky. Their duration
equals their time to maturity. Many of these bonds have terms of 20 or 30
years. With durations like that, their market values can be as
volatile as those of
common stocks. Examples of
these types of bonds are
municipal accrued-coupon bonds and
Treasury zero-coupon bonds.
Deferred-coupon bonds usually have considerable
credit risk. This is because
they tend to be issued by
corporations that lack the cash flow to meet near-term coupon
payments. Usually, they are junk bonds.
Two variants of deferred-coupon bonds are
step-up
bonds, which pay a low coupon for the first few years and a higher
coupon after that, and
payment-in-kind
(PIK) bonds, which are like regular
coupon bonds but give the issuer the
option of paying coupons in cash or in more bonds.
Securitizations are often
structured with tranches that
defer interest. In the context of
collateralized mortgage obligations, these are called
Z bonds.
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 bond Securitized debt.
bond
accrued interest
Interest that is earned but not yet paid on a bond.
compound interest
Any of several methods of crediting interest in which interest is earned on interest.
corporate bond
A bond issued by a corporation.
credit risk Risk due to
uncertainty in a counterparty's ability to meet its obligations.
duration and convexity
Risk metrics employed in fixed income markets.
fixed income
term structure Refers collectively to a spot curve, forward curve,
discount curve, yield curve or any other curve that describes the time value of
money.
interest rate risk
Risk due to uncertain future interest rates.
international
bond Any bond issued or invested in across national boarders.
junk bond
A bond whose credit rating is below BBB-.
par value A stated
value for a security.
reinvestment
risk Risk from uncertainty in the interest rate at which
future cash flows may be invested.
Treasury strip
A zero-coupon bond "stripped" from the cash flows of a Treasury security.
valuation Article about book value and market value accounting.
yield
Any of several metrics of the income or return to be earned from an investment.
Z
bond A type of CMO bond that accrues interest until it starts to pay down
principal. |
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