Accumulation Bond - Explained
What is an Accumulation Bond?
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Table of ContentsWhat is an Accumulation Bond?Tax Implications of Accumulation BondsExample of an Accumulation BondAcademics Research on Accumulation Bond
What is an Accumulation Bond?
When a bond is traded at a discount, at a price below its face value or par value, it is called a discounted bond, an accumulation bond. A bond of this nature is called an original issue discount (OID) because the price the bond is sold by its issuer is lesser than the original price or face value. Accumulation bonds are also referred to as accrual bonds. In accumulation bonds, the buyer pays less money to the issuing company but interest on bond is accumulated and paid on maturity. Since this type of bond is sold at a discount, the investor receives no interest.
Every bond has a face value at which it is traded, this is the market price at which it should be sold. An accumulation bond does not work as normal bonds, it is sold at a price lower than its face value. Accumulation bonds are sold at a discount and their interests are allows to accrue until they mature, that means the investor is not entitled to interest until the maturity time. Different investors, institutional investors and even government agencies whether at the local, state or federal level issue accumulation bonds.
Tax Implications of Accumulation Bonds
In accumulation bonds, bondholders do not receive coupon interest payments, rather, the interest on the bond occurs till the bond matures. For tax purposes, the accumulated interest are calculated and filed as interest income when filing tax reports with the Internal revenue service. This interest income has an impact on the tax return of the bondholder for that specific year. However, it is important to know that accumulation bonds suffer huge price declines especially when there is an increase in interest rates.
Example of an Accumulation Bond
This is an example of accumulation, this illustration will sharpen your understanding of how accumulation bonds work. If Company A is into production for equipment for producing fabrics and Company A is in need of cash to construct a facility for the equipment and also renovate offices used by its senior staff. The total amount needed by Company A is $850, 000. Company A can use sale of accumulation bond as a strategy to cater for its expenses, it sells the accumulation bond to a lender with an agreement that Company A pays no interest on the loan. If the lender agrees to this, the lender might offer Company A $1, 000, 000 but Company A would not be paid the entire amount at once, rather, it will be paid $850, 000 needed to rent a facility and renovate offices. The lenders holds back $150,000 since no payment of interest is attached.
Academics Research on Accumulation Bond
- Taxes on taxexempt bonds, Ang, A., Bhansali, V., & Xing, Y. (2010). Taxes on taxexempt bonds. The Journal of Finance, 65(2), 565-601. Implicit tax rates priced in the cross section of municipal bonds are approximately two to three times as high as statutory income tax rates, with implicit tax rates close to 100% using retail trades and above 70% for interdealer trades. These implied tax rates can be identified because a portion of secondary market municipal bond trades involves income taxes. After valuing the tax payments, market discount bonds, which carry income tax liabilities, trade at yields around 25 basis points higher than comparable municipal bonds not subject to any taxes. The high sensitivities of municipal bond prices to tax rates can be traced to individual retail traders dominating dealers and other institutions.
- The Tax Treatment of Municipal Discount Bonds: Rebuttal and Expansion, Kaufman, G. G. (1982). The Tax Treatment of Municipal Discount Bonds: Rebuttal and Expansion. Financial Management, 48-51. This note documents that the IRS considers the amortization of the discount on municipal bonds that is created when the bonds are issued as part of a package of serial bonds sold at par value by the issuer to an underwriter, and resold by the underwriter to investors at below par value, as a capital gain subject to capital gains income tax and not as tax-exempt income. Thus, these bonds trade at higher yields than comparable current coupon municipal bonds. Recently, issuers and underwriters have structured municipal bonds so that any discount qualifies as original issue discount and is considered tax-exempt income. Such zero coupon bonds have become popular issues.