Deferred Coupon Bonds: Definition, How It Works, Types and More

Deferred coupon bonds do not offer periodic interest payments. These bonds offer a deferred and accrued interest payment after a certain date, often at maturity. The interest payments can be deferred until maturity or a certain period.

Deferred coupon bonds are a good investment tool for investors looking for capital gains. However, it does not suit investors looking for consistent income through regular coupon payments.

Deeper Definition

Deferred interest or coupon bond comes with no regular coupon payments until a specific date, usually until maturity. The interest on these bonds accrues over time and paid to investors upon maturity.

Usually, these bonds pay accumulated interest at maturity. This accumulated payment is adjusted as the difference between the issue price and the face value of the bond. However, some bonds may start making coupon payments after a certain period, for instance, in the case of step-up bonds.

How Does a Deferred Coupon Bond Work?

Deferred bonds do not make interest payments, which is a common feature of bonds. Rather, these bonds accrue the interest over a specific period, often until maturity. Investors receive the accrued interest at maturity along with the principal.

Issuer offers deep discounts on these bonds to attract investors. For instance, a deferred coupon bond with a face value of $ 1,000 can be issued at a discounted price of $920 to attract investors. The difference between the issue price and the par value acts as the accumulated interest.

Some of these bonds make the interest payment at maturity. Other coupon bonds start making payments after a certain period. For instance, a bond with a 10 years maturity can start coupon payments after 5 years. Thus, it will act as a deferred coupon payment bond for the first five years and a regular bond for the remaining five years.

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Special Considerations with Deferred Bonds

Issuers offer bonds to raise capital. Investors look for regular income or capital gains through price appreciation. These bonds do not offer regular payments. Issuers have to offer deep discounts to attract investment in these bonds.

For instance, a deferred coupon bond with a 5% interest rate and a maturity of 10 years with a face value of $1,000 can be issued at $920. The difference of $80 acts as the return along with the principal repayment at maturity. An investor can immediately sell the bond in the secondary market, say for $ 940. The final investor will receive the principal amount plus any remaining difference of market price and the par value.

Important Types of Deferred Coupon Bonds

Here are some important types of deferred coupon bonds

Zero-Coupon

Zero-coupon bonds are the most common types of deferred interest bonds. Investors receive accumulated interest at maturity, often in the form of the price difference between the market price and the par value.

Step-Up Bonds

These bonds do not make coupon payments until a certain period. For instance, a bond can start interest payments after 5 years with a 10 year maturity period.

Toggle Notes

Toggle notes pay increased interest rates after a certain period. Investors expect higher interest rates with a deferred payment condition.

Single Rate Deferred Bonds

These bonds defer coupon payments until maturity but offer a single interest rate. Investors receive coupon payment plus principal at maturity.

Payment in Kind Bonds

These bonds work similarly to convertibles. Investors receive coupon payments in the form of other securities such as bonds or stocks at maturity.

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Example

Suppose a company issues a bond with a face value of $1,000. It comes with a coupon rate of 5%. The bond is set as a deferred coupon bond for five deferred coupon bonds for 5 years and a maturity of 10 years. The issuing company can offer some discount on the face value of the bond to attract investors, say $960 in this case.

The investor will not receive any coupon payment for the first five years. Afterward, the coupon payment will be $50 per year for the remaining five years. The company will repay the face value at $1,000 plus the $50 for the last year.

Advantages of Deferred Coupon Bonds

Deferred coupon payment bonds can offer several advantages to investors and issuers.

  • Investors are offered deep discounts on these bonds.
  • Investors can use these bonds as long-term investment tools with capital gains at maturity.
  • Issuers can save on coupon payment and yet receive investment.
  • These bonds can be used as marketable securities to seek immediate returns as well.

Disadvantages of Deferred Coupon Bonds

Deferred coupon bonds come with some disadvantages as well:

  • Investors do not receive any regular payments.
  • These bonds come with high-interest rate risks.
  • Prices of these bonds can fall in increasing interest rate markets.
  • These bonds are often issued with long-term maturity periods, hence depend on liquidity for trading.

Conclusion

Deferred coupon bonds do not offer regular coupon payments. Interest payments accrue over time until maturity. Investors use these bonds as long-term investment tools. However, these bonds are not suitable for investors looking for consistent income. These bonds come with high-interest rate risks too.

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