What Is an Accrual Bond and How Does It Work?

Accrual bonds are fixed-income securities where interest payments are not made regularly but accumulate over time and are paid with the principal at maturity. These bonds appeal to investors focused on long-term growth rather than periodic income.

Because they do not provide cash flow until maturity, accrual bonds have distinct pricing and tax implications compared to traditional bonds. Understanding their structure helps investors determine if they align with their financial goals.

Interest Accrual Features

Unlike traditional bonds that pay interest at regular intervals, accrual bonds accumulate interest internally, increasing in value over time. This compounding effect enhances the final payout. The interest rate is typically fixed, though some accrual bonds have variable rates tied to benchmarks like the Secured Overnight Financing Rate (SOFR) or Treasury yields.

The frequency of accrual—daily, monthly, or semi-annually—affects the effective yield. More frequent compounding results in a higher return. A bond accruing interest semi-annually at a 5% annual rate will generate slightly less total interest than one compounding monthly at the same nominal rate.

Certain accrual bonds, such as zero-coupon bonds, are issued at a discount to their face value, with accrued interest embedded in the price appreciation. Others, like capital appreciation bonds (CABs), follow a similar structure but are often used by municipalities to defer debt service obligations. These structures allow issuers to manage short-term cash flow constraints while offering competitive long-term returns.

Payment and Redemption

Investors receive the full payout at maturity, consisting of the original principal and all accumulated interest. Since no periodic interest payments are made, the redemption value is significantly higher than the purchase price. This structure makes accrual bonds useful for long-term financial planning, such as funding future liabilities or retirement needs.

The redemption process varies by issuer. Government-backed accrual bonds, such as U.S. Treasury STRIPS, are redeemed directly through the U.S. Department of the Treasury. Corporate or municipal accrual bonds may require investors to work through a trustee or financial institution. Some issuers offer early redemption options, though these often include call provisions that can affect total returns.

Callable accrual bonds allow issuers to redeem the bond before maturity at a predetermined price. If interest rates decline, issuers may call the bond and refinance at lower rates, reducing an investor’s expected return. Bonds with call provisions typically offer higher yields to compensate for this reinvestment risk.

Yield and Pricing

The yield on an accrual bond reflects the total return an investor can expect by holding it until maturity. Since these bonds do not pay periodic interest, yield is determined by the difference between the purchase price and final payout. The most common metric for assessing accrual bond returns is yield to maturity (YTM), which accounts for the bond’s purchase price, face value, and time until redemption.

Market conditions heavily influence pricing. Interest rate changes, inflation expectations, and credit risk all affect market value. Because accrual bonds rely entirely on compounding interest, they are highly sensitive to prevailing rates. When interest rates rise, new bonds offer higher yields, making existing accrual bonds with lower locked-in rates less attractive, which drives their market price down. When rates decline, the present value of future payouts increases, pushing prices higher.

Credit risk also affects pricing, particularly for corporate and municipal accrual bonds. Investors demand higher yields for bonds issued by lower-rated entities to compensate for the increased risk of default. This is reflected in the bond’s discount at issuance or secondary market trading prices. Bonds from issuers with strong credit ratings, such as U.S. Treasury STRIPS, trade at lower yields due to their near risk-free nature, while lower-rated bonds must offer more attractive returns.

Tax Considerations

Accrual bonds present unique tax challenges because interest income is taxed annually, even though investors do not receive cash payments until maturity. The IRS classifies the imputed interest as original issue discount (OID) income, which must be reported each year. This differs from traditional bonds, where taxable interest aligns with actual cash distributions. Investors holding accrual bonds in taxable accounts must plan for the tax liability despite lacking corresponding cash flow.

Tax treatment varies depending on the investor and the bond’s characteristics. Individual investors must include OID income on their annual tax filings using IRS Form 1099-OID, which brokers and financial institutions issue to report accrued interest. Tax-exempt entities, such as certain municipal bondholders, may avoid this obligation if the bond qualifies under IRS rules exempting interest from federal tax. However, state and local tax treatment may differ, requiring additional review of jurisdiction-specific regulations.