What is Income Bond and How it Works?

An income bond is a security instrument in which the investor only receives repayment of the face value. The coupon or interest payments are made only if the issuer generates sufficient income.

It is a rarely used instrument in the corporate world. Since there are no guaranteed returns on investment, it does not attract investors. However, companies in financial crisis, bankruptcy, or with low credit rating issue income bonds.

Income Bond – Definition

An income bond offers the only repayment of the face value to the investor. It does not offer coupon payments to investors as is the case with coupon bonds.

The coupon payments are made to the investors only if the issuer has sufficient income. Investors looking for stable income do not prefer income bonds. The only attraction for investors with these bonds can be the attractive face value of the bond.

How Does it Work?

Bonds are issued by large companies, corporations, banks, and government institutions to raise long-term capital. Bonds offer low face value and coupon payments to investors as an attraction. Income bonds do not offer guaranteed coupon payments to investors.

They are issued by companies struggling to raise capital due to default or credit rating issues. Coupon payments can only be made when the issuer has sufficient cash. Coupon payments with an income bond can fluctuate over time and till the maturity date. Since bonds are considered long-term investments, investors do not prefer a fluctuating and inconsistent coupon payment bond.

They are a favorable choice for issuers though. A company facing low credit ratings, financial crunch, or bankruptcy can use the income bond option. The issuer can only guarantee the repayment of face value without committing coupon payments.

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Income Bonds in Corporate Bankruptcies

 Companies facing solvency and bankruptcy cases often use income bonds to raise capital. An insolvent company facing a financial crisis does not enjoy high credit ratings. It becomes difficult for such companies to issue debenture bonds with high-interest rates and coupon payments.

In the US, companies filing for Chapter 11 Bankruptcy can issue these bonds to raise cash. Chapter 11 bankruptcy is often not the final verdict for a company before liquidation. The benefit for such companies is to promise the repayment of face value only. If the company succeeds and generates cash flows in the future, it can make coupon payments to income bondholders.

Income Bonds and Debt Restructuring

Another similar use of income bonds is in debt restructuring. It can happen during the Chapter 11 bankruptcy filing or in a debt crisis due to a high gearing level. In such scenarios, any company will find it difficult to raise capital from the capital market.

They are rarely used financial instruments under normal circumstances. Since the investors do not find any attractive regular payments, they do not intend to invest in these bonds. Another drawback is the lack of interest accumulation feature. They do not accumulate interest payments for the missing period when the issuer does not have sufficient income. There is no legal obligation of the issuer to make missing coupon payments.

Who Issues Income Bonds?

As investors do not find income bonds much attractive, these instruments are issued under special circumstances. Large companies with good credit ratings but facing financial crunch can issue these bonds. Companies facing bankruptcy or debt restructuring challenges can also issue income bonds.

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The prime objective of issuing bonds as debt instruments is to raise capital for the long-term. They can serve that purpose too. They can also be traded on the bond market. However, these bonds do not attract investors due to a lack of return and poor credit rating of the issuer. Investors consider them as a risky investment.

Advantages

Income bond offers several benefits to the issuers.

  • It can help businesses obtain necessary capital in bankruptcy or debt restructuring.
  • The bond issuers do not need to make coupon payments.
  • Investors can use these bonds as marketable security or as a long-term investment.
  • They provide alternative capital funding to issuers than bank loans and equity.

Disadvantages

Income bond is a risky debt instrument, it comes with several limitations and disadvantages to both parties.

  • It is issued in financial instability, hence are riskier instruments.
  • It offers only confirmed repayment of the face value.
  • Investors cannot receive consistent coupon payments.
  • Trading income bonds can be difficult due to the low demand and risky nature of the instruments.

Conclusion

Income bonds are securities that offer repayment of the face value. The issuer does not guarantee coupon payments. It is often used by companies facing bankruptcy or debt restructuring challenges. Investors find it riskier investment due to poor credit rating and low returns on investments.

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