Accumulation Bond Definition

What Is an Accumulation Bond?

An accumulation bond is a type of security that is sold at a discount, known as an original issue discount (OID). An OID is a discount from by value (also known as “face value”) at the time the bond is issued. The bond will gradually return to that value over a given period of time. In other words, the bondholder is merely giving the issuing company less money than it has legally borrowed. In exchange, the bondholder will forgo the interest income since the bond issuer is not required to make interest payments, as is typically done.

An accumulation bond is so named because the value of the bond accumulates over time. They are also known as zero-coupon bonds since the payment of interest (in this case, none) is known as a coupon.

Key Takeaways

  • An accumulation bond is one sold at a discount, known as an original issue discount (OID).
  • An original issue discount (OID) is a discount from par value at the time a bond or debt instrument is issued.
  • An accumulation bond, also known as a zero-coupon discount bond, is so named because the value of the bond accumulates over time.
  • The interest on accumulation bonds still accumulates and must be reported as interest income on the bondholder’s tax return each year.
  • Investors in accumulation bonds should be aware that accumulation bonds are at risk of suffering steep price declines during times of rising interest rates.

Understanding Accumulation Bonds

Accumulation bonds are sold for less than the face value of the bond, but will eventually return to the original face value over a period of time that is specified at the time of purchase. Generally, the more time before the bond matures, the greater the discount.

Some investors like to use accumulation bonds in their financial plans, as they can allow them to mature before eventually cashing them, and they know the exact amount they will receive at a future point when the bond matures.

Accumulation bonds mature in a reasonable amount of time, and they may yield more earned interest than other investment options. Accumulation bonds are considered to be a safe investment, but have in mind that they will not pay off until reaching maturity. In other words, they are a way for saving for the future, not a way to create a steady revenue stream.

The U.S. Treasury, corporations, and federal, local, or state government agencies often issue accumulation bonds. Most of them also trade on the major exchanges.

Advantages and Disadvantages of Accumulation Bonds

Pros

The main advantage of accumulation bonds is that they often come with higher interest yields than traditional bonds. While investors get regular interest payments from traditional bonds, with accumulation bonds, on the contrary, investors have to let the bonds mature before eventually cashing them, but they get higher yields in return.

Also, they offer a reliable, predictable payout when they are held until maturity, since investors are guaranteed a return of the full face value. For those reasons, they are considered a safe way to create a nest egg for the future.

Cons

Investors with accumulation bonds should be aware that they are volatile or very sensitive to swings in interest rates. Accumulation bonds carry the risk of suffering steep price declines when interest rates rise. Some bondholders don’t want to wait until maturity to get their payout and they sell their accumulation bonds early, but the price at that time will be subject to interest rate fluctuations.

Also, with accumulations bonds, investors have to pay taxes on income they don’t get. Even though you’re not actually getting any interest payments, and won’t realize the profit until the bond pays out at maturity, the IRS acts as if you are. In other words, the interest must be reported as interest income on the bondholder’s tax return each year. This is sometimes referred to as “phantom income”.

Pros

  • Higher interest yields than traditonal bonds

  • Reliability, predictability

Example of an Accumulation Bond

The Widget Group needs to build a new widget factory. They also need some extra money to refurbish their offices. The factory will cost $710,000, while the refurbishment will cost $33,000.

The executives of The Widget Group decide to sell an accumulation bond to finance these expenditures, promising to repay its lenders to $1 million in 15 years. But because this is an accumulation bond, the Widget Group will pay no interest on the loan.

Instead, the company will not receive the entire $1 million up front, but a discounted $743,000, which is enough to meet its new expenses. The difference of $257,000, or what the lender did not have to lend, makes up for the lack of interest income.

In this hypothetical example, the bond’s interest rate would amount to approximately 2%. The bondholderhowever, would not recognize this income all at once, either at the beginning or at the end of the bond’s maturity. That’s because the IRS sees this income as being accumulated over time.

What Is the Difference Between a Regular Bond and a Zero-Coupon Bond?

The main difference between a regular bond and a zero-coupon bond or accumulation bond is the payment of interest. A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments (they are “zero”). Instead, zero-coupon bondholders receive the face value of the bond when it reaches maturity.

Is a Zero-Coupon Bond a Discount Bond?

An accumulation bond is also referred to as discounted bond, but not discount bondwhich is a very different concept. Whereas the discounted or accumulation bond will not pay off until it reaches maturity, the discount bond will pay out ongoing interest to the bondholder for as long as the discount bond is kept operating. Thus, the accumulation bond is a way for saving for the future, while the discount bond is a way to create a steady revenue stream in the form of interest payments.

What Are the Benefits of an Accumulation Bond?

Accumulation bonds do not pay interest but instead come at a deep discount and, if they are held to maturity, bondholders are guaranteed a return of the full face value.

How Is an Accumulation Bond Taxed?

Even though bondholders don’t actually get any interest payments, the interest on accumulation bonds still accumulates and must be reported as interest income on the bondholder’s tax return each year.

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