What it means
A traditional bond pays coupons as it goes. An accrual bond pays nothing for years: each period's interest is credited to the principal, and the next period's interest is calculated on that enlarged balance.
The mechanics resemble a zero-coupon bond, with one difference. A zero-coupon bond is sold at a deep discount to face value and its return is implied by that discount, while an accrual bond states a coupon rate that compounds into the principal.
The economic effect is similar, but the contractual path of growth is different. These bonds appear most often inside mortgage structures.
The last tranche (slice) of many collateralised mortgage obligations is an accrual or Z-tranche, which waits while earlier tranches absorb the cash flow from the mortgage pool. The interest the Z-tranche forgoes is redirected to pay earlier tranches down faster, which creates a range of maturities from one pool of mortgages.
Then the switch flips. Once the earlier tranches are retired, the accrual bond begins receiving both principal and interest on its swollen balance, and cash flows suddenly become large.
Prepayment behaviour adds uncertainty here, because borrowers who repay early when rates fall can bring the payment start date forward or back. Risks concentrate in a few places.
With no coupons to reinvest, reinvestment risk largely disappears, but interest rate risk intensifies because all the value sits far in the future, so the price moves sharply when rates change. Duration (a measure of how sensitive a bond's price is to rate changes) is long, and holders are effectively making a leveraged-style bet that rates will remain friendly for years.
Buyers are typically institutions matching distant liabilities, such as pension funds and insurers. Holders usually recognise the accreted interest as income over the deferral period, even though the cash arrives years later.
For everyone else, the label is a warning: read where a bond sits in the payment queue, because last in line means exactly that.
In practice
Real-world examples.
Example
A collateralised mortgage obligation's Z-tranche receives no cash for years while earlier tranches absorb all principal and interest from the mortgage pool. Its statement shows a balance that keeps growing, but the account holds no payments.
Example
An insurer buys an accrual bond whose large payments are scheduled to line up with annuity obligations due in fifteen years.
Example
A retail investor avoids an accrual bond after learning how violently its price swings when interest rates move. A one-point change in rates can move the price of a long-dated deferred bond far more than it moves an ordinary short-dated bond.
Formula
Calculation
New balance = old balance x (1 + periodic coupon rate), repeated each period with no cash paid out
Suppose an investor holds a $100,000 accrual bond with a 10% annual coupon that is added to principal, with no payments for 3 years. After year 1 the balance is $100,000 x 1.10 = $110,000. After year 2 it is $110,000 x 1.10 = $121,000, and after year 3 it is $121,000 x 1.10 = $133,100. The $33,100 of growth is all interest, and none of it was paid out as cash. Real mortgage tranches accrue monthly, so this annual version is a simplification.Case study
Seen in the real world.
This case study is fictional and illustrative. Priya, an invented portfolio manager at a small insurance company called Northfield Mutual, needs assets that mature in twelve to fifteen years to match a block of annuity promises. Ordinary bonds force her to reinvest coupons at unknowable future rates, so she buys the accrual tranche of a mortgage deal, which pays nothing for a projected decade and then a large, scheduled stream.
Her investment committee balks at a holding that shows no cash income for years, so she explains the matching logic: the annuity payments also start in about a decade, and reinvestment risk is precisely what she is paid to avoid. Her closing note becomes policy: match the liability first, then let the income shape follow the promise. The committee's minutes record the sentence that won the vote: we are buying a date, not a yield.
Watch out
Common mistakes.
- Buying for yield without checking the payment queue; accrual tranches wait behind every earlier claim.
- Ignoring interest rate sensitivity; deferred cash flows make these among the longest-duration bonds.
- Expecting income; until the switch date the statement shows growth but the bank account shows no cash.
Questions
People also ask.
How is an accrual bond different from a zero-coupon bond?
Both defer interest, but a zero-coupon bond's return is implied by its deep discount to face value, while an accrual bond states a coupon that compounds into the principal.
Why do collateralised mortgage obligations include accrual tranches?
To reallocate time. The interest the Z-tranche skips pays earlier tranches down faster, creating a menu of maturities from one mortgage pool.
Who should hold accrual bonds?
Institutions matching distant liabilities, such as pension funds and insurers. Investors who need income or stable prices should look elsewhere, or take advice before buying.
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