What is a Deferred Interest Bond?

A deferred interest bond is a bond that provides for either reduced or no interest in the beginning years of the bond term, and compensates for it with increased interest later in the bond term. Since this type of bond is associated with firms having short-term cash flow problems, the full-term average interest rate can be high. The high rate of interest is demanded by investors, who feel that these bonds are high-risk.

Examples of Deferred Interest Bonds

Here are several examples of deferred interest bonds:

U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities). STRIPS are U.S. Treasury securities that are separated into individual principal and interest components and sold at a discount to face value. They don’t pay periodic interest but are redeemed at full face value at maturity.
Zero-coupon municipal bonds. These bonds issued by state or local governments that don’t pay periodic interest, with interest effectively “deferred” until maturity. They are generally exempt from federal taxes, and sometimes state taxes, which can make them attractive for investors in high tax brackets.
Corporate zero-coupon bonds. These bonds are issued by corporations to raise capital and are sold at a deep discount, with the interest accrued and paid at maturity. Since these are typically riskier than government bonds, they may offer higher returns.
Deferred interest mortgage-backed securities (MBS). These securities are a specific type of MBS that may defer interest payments to investors for a certain period. This can happen in mortgage pools with a "payment-in-kind" (PIK) feature, which allows interest payments to be deferred and reinvested into the bond.
Education or college savings bonds (zero-coupon bonds). Some government or educational entities offer zero-coupon bonds intended for college savings plans. They accumulate interest over time and mature around the time funds are needed for education expenses.

These bonds serve different purposes, from providing a low-risk savings option to supporting high-growth strategies, with deferred interest allowing investors to take advantage of compounding over long periods.