Any bond traded by a business at a discount. An accumulation bond is also called a discounted bond or an accrual bond.
How Accumulation Bond Works?
An accumulation bond, also known as an original issue discount (OID) bond, is issued at a discount. To put it differently, if you are the lender or bondholder, you are simply lending the issuing company less money than it could legally borrow. You, as the lender, may forego interest income in return because the bond issuer (i.e., the company offering you the bond) is not allowed to make interest payments in this case.
The term "accumulation bond" comes from the fact that the bond's value grows or accumulates over time. Another word for this kind of bond is zero-coupon discount bonds. In other words, if you own a business and you need funds for some essential things, you can sell an accumulation bond.
You should also note that every bond has a face value, which is the price you should sell in the market. An accumulation bond is different from a common bond because you sell it for less than its actual worth or valuation. You issue accumulation bonds at a discount, and their interest is allowed to accrue until maturity, meaning the investor is not entitled to interest until the maturity date. A variety of investors, governments at various tiers (local, state, and federal), and institutional investors can issue accumulation bonds.
Example of Accumulation Bond
As an example, let's say you own a toothbrush company, and you need to build a new toothbrush factory. Your company also needs additional funds to renovate your offices. The new plant should set you back $710,000, and the refurbishment will set you back an additional $33,000. Your company's executives decide to sell an accumulation bond to cover these costs, agreeing to repay their lenders up to $1,000,000 in 15 years. However, your toothbrush company will not pay interest on the loan because it is an accumulation bond.
Instead of receiving the total $1,000,000 upfront, your company will receive a subsidized $743,000, which is only enough to cover the current expenses. The $257,000 difference, or what the lender did not have to offer your company, compensates for the loss of interest income. In this scenario, the bond's interest rate will be around 2%. Bondholders (lenders), on the other hand, don't receive this income at once, either at the start or end of the bond's term because the IRS considers this revenue to accrue over time.
Now you see that both your company and the lender have something to gain when you sell accumulation bonds. Nevertheless, if you decide to invest in an accumulation bond, you should be mindful that accumulation bonds are vulnerable to steep price declines during periods of rising interest rates. If you are the bondholder, note that the interest on accumulation bonds continues to accrue; thus, you have to declare it on your tax return per year as interest income. Occasionally, this also called Phantom Income.