What Is a Deferred Bond?
A deferred bond, also known as a deferred interest bond or deferred coupon bond, is a type of debt instrument within the broader category of fixed income securities that does not pay regular interest payments throughout its term. Instead, the interest accrues and is paid as a lump sum at a later date, typically upon the bond's maturity. This structure differentiates deferred bonds from conventional bonds, which usually distribute interest (coupons) to investors periodically, such as semi-annually or annually.62
Deferred bonds are designed for investors who do not require immediate income from their investments and may be seeking to defer tax obligations or achieve a larger payout at a future point.61 The interest that accumulates over the life of the deferred bond is added to the principal amount, which is then paid out in full when the bond matures.60
History and Origin
The concept of deferring interest payments on debt instruments has been around for a considerable time, evolving alongside various financial needs. A notable development in the realm of deferred bonds came with the introduction of "zero-coupon" bonds, which are an extreme form of deferred bonds that pay no interest until maturity.59
One significant innovation in this area in the United States was the creation of the Separate Trading of Registered Interest and Principal of Securities (STRIPS) program by the U.S. Treasury in 1985.58 This program allowed financial institutions to separate the individual interest and principal components of eligible Treasury notes and bonds, effectively creating new zero-coupon securities.56, 57 Each stripped interest payment and the principal repayment become distinct zero-coupon securities that trade independently.55 This innovation provided investors with greater flexibility to tailor their cash flows and manage interest rate risk by purchasing specific future payments.54
Another type of deferred bond, "capital appreciation bonds" (CABs), gained prominence in the municipal bond market, particularly among school and college districts, as a way to finance projects by deferring principal and interest payments for many years.53 However, these instruments have faced scrutiny due to their long repayment terms and the substantial accumulation of compounded interest, leading to concerns about future tax burdens.51, 52 In some cases, legislation has been introduced to limit the terms and debt repayment ratios of CABs due to these concerns.50
Key Takeaways
- A deferred bond pays all accrued interest as a single lump sum at a later date, typically at maturity, rather than through periodic payments.49
- Zero-coupon bonds are a common type of deferred bond where the entire return comes from the difference between the discounted purchase price and the face value received at maturity.48
- These bonds can be suitable for investors who do not need current income and may benefit from tax deferral on the accumulating interest.47
- The interest on deferred bonds accrues and compounds over time, leading to a larger payment at the end of the bond's term.45, 46
- Examples include certain types of municipal bonds, corporate zero-coupon bonds, and U.S. Treasury STRIPS.44
Formula and Calculation
The calculation for the value of a deferred bond, particularly a zero-coupon bond, involves discounting its face value back to the present. The interest earned is the difference between the purchase price and the face value received at maturity.43
The formula to determine the present value (or issue price) of a zero-coupon deferred bond is:
Where:
- (PV) = Present Value (or current price) of the bond
- (FV) = Face Value (or par value) of the bond at maturity42
- (r) = Yield to maturity (discount rate or required rate of return)41
- (n) = Number of periods until maturity40
For example, if an investor purchases a deferred bond with a face value of $1,000 that matures in 5 years, and the yield to maturity is 5%, the present value would be calculated. The compounding of interest is implicit in this formula, as the bond is sold at a discount and grows to its face value.39
Interpreting the Deferred Bond
Interpreting a deferred bond primarily involves understanding its value accumulation and tax implications. Since a deferred bond does not make periodic interest payments, its value increases over time as the accrued interest is added to the principal.38 This growth reflects the original issue discount (OID) and the compounding of interest.37 The difference between the deeply discounted purchase price and the full face value repaid at maturity represents the investor's return.36
For investors, a key consideration is the tax treatment of the accrued interest. In the United States, even though interest payments are not received annually, the accrued OID on taxable deferred bonds generally must be reported as income each year.34, 35 This concept is often referred to as "phantom income." To avoid paying taxes on income not yet received, investors often hold taxable deferred bonds in tax-deferred accounts like individual retirement accounts (IRAs) or 401(k)s.33 Conversely, tax-exempt municipal zero-coupon bonds are often attractive to investors in higher tax brackets because their imputed interest is typically exempt from federal taxes, and sometimes state and local taxes, if issued by a state or local government entity within the investor's state of residence.32
The yield to maturity on a deferred bond is the annualized return an investor can expect if the bond is held until redemption.31 This metric is crucial for comparing the attractiveness of different fixed income investments.30
Hypothetical Example
Consider an investor, Sarah, who is saving for her child's college education, which is 10 years away. She wants a predictable sum at a future date and doesn't need immediate income. Sarah decides to invest in a deferred bond with a face value of $10,000 that matures in 10 years and has an implicit annual yield of 4%.
To calculate the purchase price of this deferred bond, we use the present value formula:
Sarah purchases this deferred bond for approximately $6,755.83. Over the next 10 years, the bond will not pay any interest. Instead, the interest will accrue and compound. At the end of the 10-year period, when the bond matures, Sarah will receive the full face value of $10,000. The $3,244.17 difference between her purchase price and the maturity value is the total deferred interest earned. This type of investment aligns with her long-term financial planning goal of having a lump sum available for college expenses. This example highlights the concept of compound interest in a deferred bond.
Practical Applications
Deferred bonds serve several practical applications across various sectors of the financial market. They are commonly used in:
- Long-Term Savings and Goal-Based Investing: Deferred bonds are ideal for long-term goals such as retirement planning, college savings, or large future purchases, where a lump sum is desired at a specific future date without the need for periodic income.29
- Government Finance: U.S. Treasury STRIPS are a prime example, allowing the Treasury to appeal to a wider range of investors by separating interest and principal payments.28 This helps manage the federal debt and provides the government with flexible financing options.27
- Municipal Finance: State and local governments issue capital appreciation bonds (a type of deferred bond) to fund public projects, often deferring significant repayment burdens until many years in the future.26 This structure can be attractive for jurisdictions facing short-term budget constraints or those financing projects with long lead times before generating revenue. However, the use of these bonds has been a subject of debate due to concerns about the long-term fiscal impact on taxpayers.25
- Corporate Finance: Corporations may issue zero-coupon deferred bonds to raise capital, especially when facing short-term cash flow problems, as they don't require immediate interest outlays.23, 24 These can be attractive to investors seeking capital appreciation rather than current income.
- Liability Matching: Institutional investors, such as pension funds or insurance companies, use deferred bonds to match specific future liabilities. By purchasing bonds that mature on or around the date a payment is due, they can minimize reinvestment risk.22 For instance, a pension fund might buy a deferred bond that matures when a large pension payout is scheduled.
The flexibility of deferred bonds in deferring interest payments and providing a single large payment at maturity makes them valuable tools for specific financial strategies.
Limitations and Criticisms
While deferred bonds offer unique benefits, they also come with certain limitations and criticisms that investors should consider.
One significant drawback is the concept of "phantom income" for taxable deferred bonds. Even though investors do not receive cash interest payments, the accrued interest is generally considered taxable income each year in the United States.21 This can create a tax liability without a corresponding cash flow, which can be problematic for investors holding these bonds in taxable accounts. For example, the IRS requires reporting original issue discount (OID) as it accrues, which means investors might owe taxes on income they haven't physically received.19, 20
Furthermore, deferred bonds, particularly zero-coupon bonds, tend to have higher price volatility compared to traditional coupon-paying bonds, especially in response to changes in interest rates.18 Because the entire return is paid at maturity, their duration is equal to their time to maturity, making them more sensitive to interest rate fluctuations. This can expose investors to greater market risk if they need to sell the bond before maturity.
A prominent criticism has emerged regarding "capital appreciation bonds" (CABs) used by municipal entities. While CABs allow issuers to delay payments, they often lead to significantly higher total repayment costs due to the compounding of interest over extended periods, sometimes spanning decades.16, 17 This burden is ultimately borne by future taxpayers, potentially constraining future municipal budgets and leading to concerns about intergenerational equity.15 For example, the Brookings Institution has highlighted concerns about the rising U.S. federal debt and its potential long-term economic implications, underscoring the broader risks associated with deferred obligations.13, 14 Similarly, municipal bonds, including CABs, can face scrutiny when cities confront financial instability, as seen in past discussions about New York City's municipal debt.12
Deferred Bond vs. Zero-Coupon Bond
The terms "deferred bond" and "zero-coupon bond" are often used interchangeably because a zero-coupon bond is a common and prominent type of deferred bond. However, there's a subtle distinction in their broadest definitions.
A deferred bond is a debt instrument that postpones some or all of its interest payments until a later date, often a single lump sum at maturity.11 This deferral can mean no interest payments for an initial period, followed by regular payments, or the entire interest payment is made at the end.
A zero-coupon bond is a specific type of deferred bond that makes no periodic interest payments whatsoever. Instead, it is issued at a discount to its face value, and the investor receives the full face value at maturity. The difference between the purchase price and the face value constitutes the investor's return.10 In essence, all of its interest is deferred until maturity.9
Therefore, while all zero-coupon bonds are deferred bonds, not all deferred bonds are strictly zero-coupon bonds. A deferred bond could technically involve a period of deferred interest followed by a period of regular coupon payments, whereas a zero-coupon bond defers all interest until maturity. The key confusion often arises because the "zero-coupon" structure is the most common and widely recognized form of interest deferral in the bond market.
FAQs
What is the main benefit of investing in a deferred bond?
The primary benefit of investing in a deferred bond is that it allows for the accumulation and compounding of interest over time, leading to a larger lump sum payment at maturity.8 This can be advantageous for investors who don't need immediate income and are saving for a specific future goal, as it potentially offers tax deferral if held in a retirement account or if the bond is tax-exempt.7
How is the interest on a deferred bond taxed?
For taxable deferred bonds, the interest, known as original issue discount (OID), is generally taxed annually as it accrues, even though no cash payment is received by the investor.6 This is referred to as "phantom income." To avoid this, many investors hold taxable deferred bonds in tax-advantaged accounts.5 However, interest on tax-exempt bonds issued by state or local governments is typically free from federal income tax and often from state and local taxes as well.4
Are deferred bonds riskier than other types of bonds?
Deferred bonds, particularly zero-coupon bonds, tend to be more sensitive to changes in interest rates than traditional coupon-paying bonds because their entire return is realized at maturity.3 This means their prices can fluctuate more significantly in response to market interest rate movements.2 However, if held to maturity, the investor is guaranteed to receive the face value.1 The credit risk depends on the financial health of the bond issuer.