What it means
With a normal bond, the issuer pays interest every six or twelve months. A deferred interest bond changes the timetable: for the first few years the issuer pays nothing in cash, and the interest is rolled up and compounds, meaning it earns further interest.
After the deferral period, the bond may begin paying cash interest on the larger accumulated amount, or it may pay one lump sum at maturity. The structure is popular with companies that expect cash flow to improve later, such as a business building a new plant or a company that has just been bought with borrowed money.
Early cash is needed for investment and not for interest, so deferral matches the debt service to the moment when the project starts earning. Lenders know this, and they price the bond to compensate for the extra waiting time.
For the investor, the risk is higher than with a standard bond. There is no cash coming in during the deferral period, so the investor is relying on the issuer to survive and be able to pay a larger sum later.
Interest rates in the market can also move, which changes the price of the bond while the investor is waiting. Tax and accounting treatment deserve attention.
In many countries, an investor may have to report the accrued interest as income each year even though no cash has been received, and the issuer may claim a deduction for it. The exact rules differ by country, so finance teams should confirm them with their advisers.
Deferred interest bonds are related to zero-coupon bonds, but they are not identical. A zero-coupon bond never pays interest before maturity, while a deferred interest bond has a defined point at which cash payments start.
They are also related to payment-in-kind bonds, which pay interest in the form of additional bonds.
In practice
Real-world examples.
Example
A company acquired through a leveraged buyout (an acquisition funded mainly with borrowed money) issues deferred interest bonds so that early cash can be used to cut costs and integrate the business. Cash interest begins only after three years.
Example
A property developer building a hotel issues a bond with interest deferred until the hotel opens. Bondholders accept this because the hotel's revenue is the source of repayment.
Example
An investment fund holds a deferred interest bond within a diversified portfolio. The fund's accountants record the accrued interest each year, although no cash has been received, and report it as part of the fund's income.
Formula
Calculation
Accreted value after the deferral period = face amount x (1 + annual rate) ^ number of years
A company issues $1,000,000 of bonds carrying 8% interest, with all interest deferred and compounded annually for three years. After year one, the amount owed is $1,000,000 x 1.08 = $1,080,000. After year two it is $1,080,000 x 1.08 = $1,166,400. After year three it is $1,166,400 x 1.08 = $1,259,712. Cash interest after year three is then paid on $1,259,712, so at 8% the first cash payment would be $1,259,712 x 0.08 = $100,777 (rounded to the nearest dollar).Case study
Seen in the real world.
Tidewater Renewable Energy is an illustrative, fictional company building a wind farm that will not produce income for about three years. Its finance director was worried that regular interest payments on a conventional bond would drain the cash needed for construction.
She issued a deferred interest bond with interest rolled up for three years and cash payments afterwards. The bond carried a higher rate than a standard bond, but the cash saved during construction was more valuable to the company than a lower coupon.
Tidewater is a made-up example. The wind farm opened on schedule, and the interest burden began when the revenue did, which is exactly the match the structure is designed to deliver.
Watch out
Common mistakes.
- Assuming that no cash interest means no interest cost, when the interest accumulates and the amount owed grows each year.
- Treating a deferred interest bond as the same as a zero-coupon bond, when it usually switches to cash payments after a set period.
- Ignoring the issuer's credit risk, which is greater when the investor receives nothing for several years.
Questions
People also ask.
Why would an issuer choose a deferred interest bond?
It preserves cash in the early years, when the business is investing or recovering, and shifts payments to a time when it can afford them.
Is the deferred interest taxable before it is paid?
In many countries accrued interest must be reported as income as it builds, even without a cash payment, but the rules vary and professional advice is needed.
How does it differ from a payment-in-kind bond?
A payment-in-kind bond pays interest in extra bonds, while a deferred interest bond simply rolls up the interest and pays later.
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