Deferred interest bond: Meaning, Criticisms & Real-World Uses

What Is Deferred Interest Bond?

A deferred interest bond is a type of fixed-income security that does not pay out periodic interest payments to bondholders during its life. Instead, the interest accrues and compounds over the bond's term, with the full principal and accumulated interest paid as a single lump sum at the maturity date. This structure makes them a form of debt instrument where the original issue discount (OID) represents the total interest earned over the bond's life. Such bonds are often issued at a significant discount to their face value, with the difference between the issue price and the stated redemption price at maturity constituting the deferred interest.

History and Origin

The concept of deferred interest in bonds gained prominence with the widespread adoption of zero-coupon bonds, which are a direct form of deferred interest bonds. While the underlying principle of discounting future payments has existed for centuries, the modern issuance and market for zero-coupon bonds, particularly by governments, began to formalize in the late 1970s and early 1980s. A significant moment for these instruments was their use in the "Brady Plan" in the late 1980s and early 1990s, where U.S. Treasury zero-coupon bonds were sold to countries like Mexico as collateral to restructure commercial bank debt. For example, in March 1990, the U.S. Treasury sold $30.2 billion in zeros (face value) to Mexico for $2.990 billion as part of this restructuring effort.⁶ This showcased their utility in large-scale financial engineering and debt management.

Key Takeaways

Deferred interest bonds pay all accumulated interest and principal in a single payment at maturity.
They are typically issued at a discount, with the difference between the issue price and face value representing the interest.
Investors do not receive regular cash flow from these bonds.
For tax purposes, the accrued interest, often referred to as Original Issue Discount (OID), must generally be reported as taxable income annually, even though no cash is received.
These bonds can be highly sensitive to changes in market interest rates.

Formula and Calculation

The value and yield of a deferred interest bond are intrinsically linked to the concept of Original Issue Discount (OID). The yield to maturity (YTM) for such a bond can be calculated using the following formula, which relates the bond's current price to its future face value, considering the time until maturity:

P = \frac{FV}{(1 + YTM)^N}

Where:

( P ) = Current Price of the bond
( FV ) = Face value (or stated redemption price at maturity)
( YTM ) = Yield to maturity (annualized)
( N ) = Number of years to maturity

This formula can be rearranged to solve for the yield to maturity, illustrating the implicit interest rate the bond earns over its life. The total interest income from a deferred interest bond is simply the difference between its face value and its issue price.

Interpreting the Deferred Interest Bond

Interpreting a deferred interest bond primarily involves understanding its implied yield and the taxation of its accrued interest. Since no coupon payments are made, the entire return to the bondholder comes from the appreciation of the bond's value from its discounted issue price to its face value at maturity. A higher discount indicates a higher yield to maturity for a given maturity period.

For individual investors, a crucial aspect is the concept of "phantom income." Even though no cash is received until maturity, the Internal Revenue Service (IRS) generally requires bondholders to report a portion of the accruing Original Issue Discount (OID) as taxable income each year.⁴, ⁵ This means investors need to have alternative sources of cash to pay taxes on income they haven't yet physically received. This characteristic makes deferred interest bonds, especially those issued with significant OID, less suitable for investors seeking regular cash flow or those in higher tax brackets unless held within a tax-advantaged investment portfolio.

Hypothetical Example

Consider a hypothetical deferred interest bond with a face value of $1,000 that matures in 10 years. Suppose this bond is issued at a discounted price of $600.

Issue Price: $600
Face Value: $1,000
Maturity: 10 years

The total deferred interest over the 10 years is $1,000 (face value) - $600 (issue price) = $400.

To calculate the approximate annual yield to maturity, we can use the formula:

\$600 = \frac{\$1000}{(1 + YTM)^{10}}

Solving for YTM, we find that the approximate annual yield is about 5.24%. Each year, a portion of the $400 interest accrues. For tax purposes, the bondholder would report a portion of this 5.24% yield as OID income annually, even though no cash payment is received until the bond matures in 10 years and the investor receives the full $1,000.

Practical Applications

Deferred interest bonds, largely represented by zero-coupon bonds, have several practical applications in investing and financial planning.

Target-Date Investing: They are frequently used for target-date investing strategies, such as saving for a child's college education or a future lump-sum liability. By purchasing a bond that matures on or around the target date, an investor can match a future liability with a guaranteed payment (for government-backed bonds), eliminating reinvestment risk.
Asset-Liability Matching: Institutional investors, such as pension funds and insurance companies, utilize these bonds for asset-liability matching. They can purchase deferred interest bonds that mature at the same time as their future liabilities, providing a precise hedge against future obligations.
Yield Curve Strategies: Traders and portfolio managers may use deferred interest bonds to take positions on the shape of the yield curve, as their price sensitivity to interest rate changes (duration) is generally higher than that of coupon bonds with the same maturity.
Collateral: As seen in historical debt restructuring efforts, these bonds can serve as collateral in complex financial arrangements. The U.S. Treasury has issued zero-coupon bonds for this purpose.³

Limitations and Criticisms

While deferred interest bonds offer specific advantages, they also come with notable limitations and criticisms.

Phantom Income Taxation: As discussed, a significant drawback for individual investors is "phantom income" taxation. The investor must pay taxes on interest income annually that has not yet been received in cash. This can create a cash flow mismatch, requiring investors to use other funds to cover the tax liability. The IRS provides guidance on how to treat Original Issue Discount (OID) as income.²
Interest Rate Sensitivity: Deferred interest bonds are highly sensitive to changes in market interest rates due to their long duration. Their prices can fluctuate significantly with even small changes in rates. In a rising interest rate environment, the value of existing deferred interest bonds is likely to fall more sharply than that of bonds that pay regular interest.¹ This sensitivity increases with longer maturities. Effective risk management is crucial when incorporating these bonds into an investment portfolio.
No Current Income: For investors who rely on a steady stream of income from their investments, the lack of periodic interest payments makes deferred interest bonds unsuitable.
Liquidity Concerns: While publicly traded, certain less common issues of deferred interest bonds might have lower liquidity compared to actively traded coupon bonds, potentially making them harder to sell at a fair price before maturity.

Deferred Interest Bond vs. Zero-Coupon Bond

The terms "deferred interest bond" and "zero-coupon bond" are often used interchangeably, and for most practical purposes, they refer to the same type of financial instrument. A zero-coupon bond is a specific type of debt instrument that does not pay interest periodically but instead sells at a discount and pays its face value at maturity. The interest is "deferred" until the end of the bond's life.

The key distinction, if any, is largely semantic or contextual. "Deferred interest bond" highlights the mechanism of interest payment, where interest accumulation is postponed to maturity. "Zero-coupon bond" emphasizes the absence of coupon payments. Both possess the defining characteristic of Original Issue Discount (OID), where the interest accrues internally rather than being paid out regularly. Therefore, a zero-coupon bond is a specific and widely recognized form of a deferred interest bond.

FAQs

How do I receive interest from a deferred interest bond?

You do not receive periodic interest payments. All the accumulated interest, along with the original principal, is paid to you in a single lump sum when the bond reaches its maturity date.

Are deferred interest bonds risky?

Like all fixed-income securities, they carry interest rate risk; their market value can fluctuate significantly with changes in market interest rates. They also carry credit risk, which is the risk that the issuer might default on its payment obligations, although this risk is minimal for U.S. Treasury securities.

Do I have to pay taxes on deferred interest bonds every year?

Yes, generally. Even though you don't receive cash interest, the Internal Revenue Service (IRS) requires you to report a portion of the accrued interest, known as Original Issue Discount (OID), as taxable income each year. This is often referred to as "phantom income."

Why would an investor choose a deferred interest bond?

Investors might choose deferred interest bonds for specific financial planning goals, such as saving for retirement or college tuition, where a lump sum is needed at a future date. They can also be used to lock in a yield for a long period without concerns about reinvesting interest payments.

Can I sell a deferred interest bond before maturity?

Yes, deferred interest bonds are typically traded on secondary markets. However, their market value will fluctuate based on prevailing market interest rates, and you might sell it for more or less than your purchase price.