Deferred Coupon Bond

A deferred Coupon Bond is a bond that interests are paid at the end of the maturity date.  The investors will not receive an interest payment on an annual basis, but the total interest will be paid at the end of bond life.

Bonds are the debt instruments issued by the corporation or government. THey issue the bonds to raise more capital and promise to pay back principal plus interest. It is like the loan agreement that company borrow cash from the investors and promise to pay it back. 

The investor who purchases the bonds expects to collect the money back on the maturity date. In addition, they also expect to earn extra money at the end of each year. It is called interest which depends on the rate on the bond. 

Normally, bondholders will receive the annual interest payment from the issuer and principal on the maturity date. The interest will depend on the coupon rate state on the bond.

On the other hand, deferred coupon bondholders will not receive interest on a regular basis. The interest will be accrued over the period based on the rate and paid with the principal on the maturity date.

Even the company does not pay the interest every year, but they have to record the interest expense based on the interest rate. The interset expense needs to accrue every year and be paid on the maturity date. 

In order to attract the investors, company needs to discount the bonds to below the par value and promise to pay back the par value on the maturity date. The investors will gain the difference between the issued amount and the par value. For sure the discounted amount will reflect base on the market rate and bond term. So even it is called a zero interset bond, but it also depends on the bond term and market rate.

Deferred Coupon Bond Formula

We use this to calculate the bond price to ensure that the discounted amount reflects the market rate and bond term.  

Bond Price = Face Value / (1+r)^n 

Bond price: is the price that the issuer plan to sell to the market 

Face value: or par value is the value stated on the bond and investors expect to receive this amount on the maturity date. 

n: number of years till the maturity date

r: is the required rate of return of investor or market rate or interest rate  (annual rate)

Deferred Coupon Bond Example

Company issue 1,000 zero-coupon bonds with a par value of $ 5,000 each. As the bonds do not provide any annual interest to the investors, so they have to be discounted and pay back the full value of par value. The market rate is 5% and the term of the bonds is 4 years. 

Please calculate the bond price that company needs to sell to attract investors. 

In order to calculate the bond price, we have to discount it back to the present value. Investors invest in the present value and expect to receive the par value on the maturity date. 

Bond price = 5,000/(1+5%)^4 = $ 4,113.5 per bond

The company needs to discount $ 886.5 ($ 5,000 – $ 4,113.5) to attract investors. They simply sell the bond for $ 4,113.5 and promise to pay back $ 5,000. The difference between the selling price and par value is the profit that the investors will receive. It is the interest expense that the issuer needs to pay to borrow the money from investors. 

We may think that a zero-coupon bond does not have interest expense, but it is just the name to represent the bond that does not produce annual interest income. The issuer still needs paid interest expenses otherwise the investors will not give the money to the business without any return. 

Deferred Coupon Bond Journal Entry

When the company issues bonds to the market, they need to debit cash and credit bonds payable. Based on the example above, company issue bonds at $ 4,113.5 per bond, so they need to debit cash of $ 4,113.5 and credit bonds payable for the same amount. 

Account Debit Credit
Cash  4,113.5
Bonds Payable 4,113.5 

This transaction will increase the cash that receives from the selling of bonds and bonds payable is the liability that needs to pay back to the bondholder at the maturity date. 

At the end of the first year, the company needs to record interest expenses for the period. As the company does not pay any interest to investors, the interest expense will increase the bonds payable to the par value amount. 

Interest expense = $ 4,113.5 * 5% = $ 205.67

The company needs to debit interest expense $ 205.67 and credit bonds payable. 

Account Debit Credit
Interest Expense 205.68
Bonds Payable 205.68

This transaction will increase interest expense in the income statement and increase the bonds payable on the balance sheet. 

At the end of year 1 to year 4, the company needs to record interest expense and credit bonds payable. By the end of the 4th year, bonds payable will increase to $ 5,000 which is equal to bond par value. And the bond payable will be settled when the company payback to bondholder. 

Year Beg Balance Interest Expense Ending Balance
Year 1 4,113.51 205.68 4,319.19
Year 2 4,319.19 215.96 4,535.15
Year 3 4,535.15 226.76 4,761.90
Year 4 4,761.90 238.10 5,000.00

The interest expense will increase from year 1 to year 4 as the bonds payable increase as well. Interest expense = beginning balance multiply by 5%. 

Type of Deferred Coupon Bond

  • Zero-Coupon Bond: it is one type of deferred coupon bond as the bond issuer does not pay any interest but only the par value at the end of the maturity date. To compensate for the interest, issuer needs to sell the bond at a deep discount and pay back full amount.
  • Step-Up Bond: this bond has some interest payment during the period however, it keeps increasing the rate when bond faces maturity date.
  • Payment in kind Bonds: this bondholder will receive the interest payment in different forms besides cash. And the issuer can defer the payment till the maturity date.

Advantages Deferred Coupon Bond

  • Higher return: Deferred Interest bond usually has higher return due to the nature of the compound interest rule.
  • Higher interest rate: The issuers need to give a higher interest rate to convince the investors to purchase this type of bond. Investors will not receive any cash flow during the entire bond life, so it requires a higher rate to attract them.
  • Delay tax: Investors will not receive interest payment, so it will not be their income tax expense too. It allows them to make proper tax planning.
  • Delay paying interest: The issuer will be able to save interest payments and use the fund for other purposes. It allows the management to make proper cash flow planning.
  • Low investment: This kind of bond require low investment from the investors. Due to the nature of bonds, issuers need to provide a huge discount to attract investors. 

Disadvantages of Deferred Coupon Bond

  • Risk of default: Investors do not receive any cash inflow, it will be a problem if company goes bankrupt. Bonds can be the default for some reason, so investors will lose everything.
  • No Cash flow: The investors will not receive any cash flow between the issue and maturity date. They may force to sell the bond if they need some cash flow urgently. While the normal bond, they will receive cash flow every year. 
  • Tax is delayed but not wave: Investors may be able to take advantage of taxable income, however, it is not waved and they have to pay them on the maturity date.