Accretion refers to the gradual and incremental of earnings and assets resulting from a company’s internal growth, business expansion, a merger, or acquisition. In financial terms, accretion describes the additional income investors expect to receive when they purchase bonds at a discount and hold them until maturity.
How Accretion Works
Accretion is a term used in the corporate finance world and the securities market. People in the corporate finance world often refer to accretion as creating value in an organization through a transaction or organic growth. When a company acquires new assets for less than its current market value (CMV), this is considered accretion. Similarly, accretion can occur when a company acquires assets expected to grow in value following the transaction.
Investors who purchase bonds below their par value (face value) buy them at a discount in the securities market. On the other hand, an investor who buys bonds above their par value buys them at a premium, known as amortization.
Bond accretion, therefore, refers to the bond’s growth in value as time-lapse. As the bond approaches maturity date, its value increases till the bond converges with its face value. For example, if a particular bond’s face value is $1,000, but the bond is offered at $850, the discount is $150 ($1,000 - $850). During the bond’s life, its value will increase till it reaches a par value of $1,000.
Examples of Accretion
An example of corporate finance accretion is in the acquisition of a company (Y) by another (X). Let’s assume that company X’s earnings per share (EPS) is $200, while company Y’s EPS is $100. When Company X acquires Company Y, Company X’s EPS increases to $300. Here there’s a 50% accretive resulting from the increase in value.
Another example: an investor buys a bond with a par value of $1,000 for a discounted price of $750, which will mature in 10 years. This purchase is considered accretive. The bond’s payout includes the initial investment and interest. The investor may pay the interest as a lump sum on maturity or at regular intervals depending on the purchase.
Types of Accretion
There are two main ways of accounting for bond accretion:
- Straight-line method: Here, the bond’s increase in value is evenly spread throughout its term. If the bond has a five-year term and the company reports its financial status every quarter, there will be 20 periods until maturity. The $100 discount is divided throughout the 20 periods, which totals $7.5 per quarter. Essentially, there will be a $7.5 accretion in each quarter until the bond matures.
- Constant Yield: Unlike the straight-line method, here, the increment is not even, with some periods showing more significant gains than others. The bond gains more value closest to the maturity date. The first thing you’ll need to do is establish the Yield to Maturity, i.e., how much the bond will earn until it matures. You can do this using the bond’s face value, years to maturity, price, and the bond’s interest rate.