Bonds are income instruments issued by large financial institutions and Governments through the treasury. Bonds work as debt or borrowing instruments for the issuers and investment opportunities for the investors. Governments and large financial institutes borrow money through a bonds issue.
Bonds come with a face or par value, duration or maturity date, and a coupon or interest rate. Depending on the issuer’s credibility the bond issue price may be different (usually lower) to the face or par value. Investors receive regular payments through interest or coupon on bonds with pre-determined interest rates.
Deferred bonds are one type of bond where the investors do not receive coupon payments until a specific period or till maturity. These bonds do not pay periodic payments to investors.
The coupon payments accrue over time with deferred coupon bonds and paid to the investors with the principal on maturity. Typically, deferred bonds hold coupon payments for a specific period of bond life.
The deferred coupon bonds may start coupon payments to the investor after a specific period. For example, a deferred coupon bond with 10 year maturity may start coupon payments from the 6th year onwards.
Deferred bonds paying no coupon to investors are often referred to as Zero-coupon bonds. These bonds make no-interest payments to investors. The only investment return with deferred coupon payments is the price appreciation of the bond market value.
Why Investors invest in Deferred Coupon Bonds?
Governments and large companies issue deferred and zero-coupon bonds with significantly lower issue prices than the par value. For example, a deferred coupon bond with 10-year maturity having a face value of $100 may be issued at a discount of $95.
Deferred bonds may offer coupon payments after a certain period, say from the 6th year onwards for a coupon rate of %4.
The investors’ attraction with deferred coupon bonds is to receive the coupon or interest later on or to resell the bond immediately above $95. The investors will be able to sell the deferred bond in the market if the interest rates fall.
A lower interest rate will make a new bond issued at full par value less attractive in the market, which drives the demand for deferred bonds. The investors will then be able to sell the deferred coupon bonds above the discounted issue price.
Important Considerations with Deferred Coupon Bonds:
Investors may be interested in deferred coupon bonds if they wish to resell in the market. If the bond is issued for a short maturity life it may also attract the investor.
For example, a 2-year deferred coupon bond with a 5% coupon rate of $100 will repay the investor coupon plus the initial investment in 2 years.
Large companies issue deferred coupon bonds to fund specific business expansions or projects. They hold back the coupon payments until the cash flows start with project completion. For investors, a deferred bond issued at discount may also indicate the poor credit rating of the issuer.
Benefits of Deferred Coupon Bonds:
Issuing bonds with a discount coupon price and paying deferred coupons may not seem feasible for issuers but it brings cash benefits for them. The investors may also find some advantages of investing in deferred bonds.
- Investors may sell the deferred coupon bonds purchased for discount issue price
- Investors may benefit from delayed taxes on deferred coupon receipts
- Deferred Coupon bonds offer higher yields to investors than bank deposits
- Bonds are safer investment options than stocks, which attracts individual investors looking for regular income post-retirement
- The issuers can finance a specific business expansion or project by attracting investors for a discount price
The risks associated with deferred coupon bonds are usually the same as with other bond investments.
- The issuer company may default on bond repayment upon maturity
- Deep discount offered on deferred coupon bonds may reveal a lower credit rating of the issuer
- The issuer may not attract sufficient investment with a discount bond price
- Investors’ tax benefits get deferred till the maturity of the bonds, not waived-off
Investors usually invest in low-yield investments like deferred coupon bonds to resell. The inverse interest rate relation with bond market demand plays a crucial role in bond demand. The issuers are keen to secure cash needs by offering a discounted issue price to lure in the investors.