Accrual Bond Explained: How It Works and Pricing Trends in 2025

What Is an Accrual Bond?

An accrual bond is a type of bond that postpones interest payments until maturity, similar to a zero-coupon bond, but with a fixed coupon rate applied to the principal. Instead of receiving periodic interest payments, the interest accumulates and is added to the principal balance, compounding over time.

Key Highlights

• Accrual bonds defer interest payments until maturity, allowing interest to compound on the growing principal.
• They are typically issued at a significant discount to face value, reflecting the accumulated interest.
• These bonds carry higher interest rate risk due to their longer duration and lack of periodic payments.

How Do Accrual Bonds Work?

Unlike traditional bonds that pay interest through coupons periodically, accrual bonds accumulate interest, which is added to the principal. This means the bond's principal grows over time, and the final payment at maturity includes both the original principal and the accrued interest.

Accrual bonds often have long maturities, ranging from 20 to 25 years, and are commonly issued by corporations. Although no interest payments are made during the bond's life, investors must report the imputed interest as taxable income annually, as per IRS regulations.

Interest payments may also be deferred until a later date beyond maturity, especially in structures like collateralized mortgage obligations (CMOs) where a 'Z tranche' accumulates interest before paying out.

Accrual Bonds vs. Zero-Coupon Bonds

While both accrual bonds and zero-coupon bonds delay interest payments, accrual bonds feature a stated coupon rate, providing clarity on the interest earned. Both types minimize reinvestment risk since payments are deferred, but accrual bonds generally have longer durations, increasing exposure to interest rate fluctuations.

Investment Considerations in 2024

Investors interested in accrual bonds should weigh the benefits of compounded interest growth against the increased interest rate risk and tax implications. These bonds can be attractive for long-term growth strategies, especially in low-interest environments where deferred payments may yield higher overall returns.

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