Accrual bond: Meaning, Criticisms & Real-World Uses

What Is an Accrual Bond?

An accrual bond, also widely known as a zero-coupon bond, is a type of debt security that does not pay periodic coupon payments to investors. Instead, investors purchase accrual bonds at a discount bond to their face value and receive the full face value (or par value) when the bond reaches its maturity date. The return on an accrual bond comes from the difference between the discounted purchase price and the higher face value paid out at maturity. This distinct structure positions accrual bonds within the broader category of fixed-income securities.²⁴

History and Origin

While bonds with periodic interest payments have a long history, the concept of a bond that accrues interest without paying it out until maturity gained more formal recognition and widespread use with the advent of "strip bonds." In the United States, a significant development occurred with the introduction of Separate Trading of Registered Interest and Principal Securities (STRIPS) by the U.S. Treasury in the mid-1980s. This program allowed the individual interest and principal components of a regular Treasury bond to be separated and traded as distinct zero-coupon securities. This innovation effectively created a liquid market for sovereign zero-coupon bonds, which had previously been less common or primarily found in the form of Treasury bills (which are short-term zero-coupon instruments).²³

Key Takeaways

Accrual bonds do not make regular interest payments to bondholders.
They are purchased at a price below their face value and mature at their full face value.²²
The investor's return is realized as the difference between the purchase price and the face value received at maturity.
Accrual bonds are often used for long-term financial planning, such as saving for college expenses or retirement.²⁰, ²¹
Unlike coupon-paying bonds, accrual bonds are not subject to reinvestment risk because there are no interim interest payments to reinvest.¹⁹

Formula and Calculation

The price of an accrual bond can be calculated using a present value formula, reflecting the discounted nature of the bond's purchase price relative to its future payout. The formula for pricing a zero-coupon bond, assuming semi-annual compounding (which is common for bonds), is as follows:

P = \frac{FV}{(1 + \frac{r}{2})^{2n}}

Where:

( P ) = Current Price of the Accrual Bond
( FV ) = Face value (or Par Value) of the bond
( r ) = Annual yield to maturity or required rate of return
( n ) = Number of years until maturity date

This formula discounts the future face value back to the present, based on the prevailing interest rates and the time remaining until maturity.¹⁸

Interpreting the Accrual Bond

Interpreting an accrual bond primarily involves understanding the yield an investor will receive if the bond is held until its maturity date. Since there are no intermediate cash flows, the entire return is embedded in the difference between the purchase price and the face value. This makes accrual bonds particularly attractive to investors who seek a predictable, lump-sum payout at a specific future date, often to meet a known financial obligation. The lower the purchase price relative to the face value, the higher the implied yield. This characteristic also makes them highly sensitive to changes in prevailing market interest rate risk. For instance, a 10-year U.S. zero-coupon bond yield was 4.49% in July 2025, according to the United States Federal Reserve.¹⁷

Hypothetical Example

Suppose an investor wants to save for a child's college education, which is anticipated to cost $20,000 in 15 years. They find an accrual bond with a face value of $20,000 maturing in 15 years that offers an annual yield of 4.5%, compounded semi-annually.

Using the formula:
( FV = $20,000 )
( r = 0.045 )
( n = 15 ) years

P = \frac{\$20,000}{(1 + \frac{0.045}{2})^{2 \times 15}} = \frac{\$20,000}{(1.0225)^{30}} \approx \frac{\$20,000}{1.9423} \approx \$10,297.84

The investor would pay approximately $10,297.84 today for this accrual bond. When the bond matures in 15 years, the investor will receive the full $20,000 face value, having locked in their return without needing to manage interim coupon payments.

Practical Applications

Accrual bonds are utilized across various sectors for both issuers and investors. Governments, such as the U.S. Treasury (through STRIPS), corporations, and municipalities, issue these bonds.¹⁵, ¹⁶

For investors, primary applications include:

Long-Term Savings Goals: Their single, lump-sum payout at maturity makes them ideal for planning for future fixed expenses like college tuition, retirement income, or a down payment on a home.¹³, ¹⁴
Asset-Liability Matching: Institutional investors, such as pension funds or insurance companies, use accrual bonds to match specific future liabilities with precise cash flows, reducing uncertainty.¹²
Hedging: Due to their high sensitivity to interest rate changes (a characteristic known as duration), long-dated accrual bonds can be used by sophisticated investors to hedge against movements in interest rates or to express a view on future interest rate directions.
Diversification: Accrual bonds, particularly high-quality government-issued ones, can offer a diversification benefit to a portfolio, especially during periods of market volatility, as they often move inversely to stock prices.

The direct estimation of zero-coupon yields and their impact on bond prices is an active area of research in financial economics, facilitating robust models for fixed-income analysis.¹¹

Limitations and Criticisms

Despite their advantages, accrual bonds come with specific limitations and criticisms:

Phantom Income Taxation: In many jurisdictions, including the U.S., the accrued interest on an accrual bond is subject to annual income tax, even though the investor does not receive any cash until maturity. This "phantom income" means investors may owe taxes each year without having received any corresponding cash flow, unless the bonds are held in a tax-deferred account or are tax-exempt, like certain municipal bonds.¹⁰
High Interest Rate Risk: Accrual bonds are highly sensitive to changes in interest rates. Because all the return is deferred to maturity, their prices can fluctuate significantly in the secondary market if interest rates move. If an investor needs to sell an accrual bond before maturity when interest rates have risen, they may face a substantial loss.⁹
Inflation Risk: Since the future payout is fixed, the purchasing power of the face value received at maturity can be eroded by inflation over long periods, especially for very long-dated accrual bonds.
Lack of Liquidity: While U.S. Treasury STRIPS are highly liquid, some other types of accrual bonds, particularly those issued by smaller corporations or certain municipal bonds, may have less active secondary markets, making them harder to sell quickly without impacting the price.

Accrual Bond vs. Coupon Bond

The fundamental difference between an accrual bond and a coupon bond lies in how they deliver returns to investors.

A coupon bond pays fixed or variable interest payments (coupons) to the bondholder at regular intervals, typically semi-annually, until the maturity date, at which point the original principal amount is repaid. The investor receives ongoing income.⁸

In contrast, an accrual bond (or zero-coupon bond) does not pay any interest throughout its life. Instead, it is sold at a discount to its face value. The investor's return is the difference between this discounted purchase price and the full face value received at maturity. This means all the interest is "accrued" or built into the bond's value and paid as a single lump sum at the end of the term.⁷ The choice between the two often depends on an investor's need for current income versus a future lump sum, and their tolerance for interest rate risk and "phantom income" taxation.

FAQs

How does an accrual bond generate returns?

An accrual bond generates returns by being purchased at a price below its face value (a discount). The investor receives the full face value when the bond matures. The difference between the purchase price and the face value is the investor's profit, representing the accrued interest over the bond's life.⁶

Are accrual bonds subject to taxes?

Yes, in many countries, including the U.S., the "imputed interest" or "phantom income" on an accrual bond is generally taxable each year, even though the investor doesn't receive any cash until the bond matures. To avoid this annual tax liability, many investors hold accrual bonds in tax-deferred accounts, such as IRAs or 401(k)s, or purchase tax-exempt municipal bonds.⁵

What types of issuers offer accrual bonds?

Accrual bonds are issued by a variety of entities. These include government bodies (like the U.S. Treasury through STRIPS), state and local governments (as municipal bonds), and corporations (as corporate bonds).³, ⁴

Why would an investor choose an accrual bond over a traditional bond?

Investors often choose an accrual bond for specific long-term financial goals where a predictable lump sum is needed at a future date, such as saving for college or retirement. They simplify financial planning by removing the need to reinvest periodic coupon payments and offer a clear future value.¹, ²