Deferred coupon bonds are ones where interest is paid at maturity. The capital structure of a business needs certain financial instruments on which the interest can be deferred.
The traditional plain vanilla bond pays interest periodically. It can be yearly, semi-annually, or quarterly depending upon the company’s financial policies. When a company acquires finances, it is obliged to pay interest on time. During troubled times in business, paying interest periodically might become difficult for the company.
What is a Deferred Coupon Bond?
The interests or the coupons on the bond are accrued over the life of the bond. The issuers of the bond are not obliged to pay interest periodically. They can defer the interest payable for a certain period and pay the accrued interest in one go. When the bond matures, the accrued interest along with the principal amount is paid to the bondholder. This is called a Deferred Coupon Bond.
How Deferred Coupon Bond Works?
The interest payment on this bond is delayed for a particular period of time. On maturity or from a certain predetermined period, the issuer starts paying the interest. The interest or the coupons on the bond are accumulated over the deferred period mentioned in the bond indenture. For example, you invest INR 10,000 in a five-year deferred bond which pays 8% annually as a coupon. After one year, you will not receive INR 800 as the interest on the bond. You will receive the accumulated interest at the end of 5 years.
Types of Deferred coupon Bonds
On this bond, the interest keeps on adding till the maturity of the bond. There is no coupon payment between the issuance date and the maturity date. On maturity, a lump-sum amount is paid to the investor. This is a summation of the principal and the deferred interest. Deferred coupon bonds can be Zero-coupon bonds for a specific period of time and then pay a certain interest for the remaining period till maturity. For example, a deferred coupon bond with 4 years as a deferred period with a coupon of 6% will not pay any interest for the first four years from the issuance date. After these initial 4 years, 6% interest will be paid to the investor at a predetermined period.
Single Rate Deferred Interest Bonds
These deferred interest bonds pay interest on maturity at a single coupon rate. Assume a bond with an annual yield of 5%, and its coupons deferred till maturity. At maturity, the investor will be paid the principal of the bond. Along with this, 5% interest for the total deferred period is also paid.
This deferred bond is also known as a toggle note. The company issuing these bonds can pay interest after a certain period. During that period, the interest on the bond keeps on accruing. Bondholders accept this bond against the condition that if the issuer defers the interest payment, then at a later date, it has to increase the rate of interest. For example, a company paying 4% interest on step-up bonds defers interest payments till maturity. On maturity, the company will pay interest at an increased rate (say) 5.5% for all the deferred periods.
Payment in Kind Bonds
Issuing a company of payment in kind bond can pay interest in the form of another financial instrument instead of cash interest payments. The issuing company can choose to defer the cash interest payments. Later the bonds are exchangeable against other financial assets of the company. This helps the company avoid coupon payments in cash when there is a cash crunch in the business.
Advantages of Deferred Coupon Bonds
Investors seeking financial instruments instead of bank savings accounts can invest in deferred coupon bonds. They serve as an alternative to a regular savings account. Another advantage of investing in these bonds is that they can be purchased at deep discounts. The issuing company can avoid paying interest to the deferred coupon bondholder in a cash crunch. This helps the company run its operation smoothly even in a cash crisis situation.
Deferred coupon bonds are a great choice for long-term investors and not for periodic income seekers. Thus, the issuing company can concentrate more on its business operations with no periodic coupon payments. This gives them flexibility in paying interest/cost of borrowing funds and helps expand businesses.
Also, read about various other Types of Bonds.