Income bond definition
/What is an Income Bond?
An income bond is a bond that pays interest only if the issuing entity has earned income. This approach to interest payments differs from what is used for a conventional bond, where interest is due on an ongoing basis, irrespective of the earnings of the issuer.
The amount of interest paid may vary with the earnings of the entity, so investors are essentially participating in the earnings of the business. This also means that investors share in the risk of the issuer, since no earnings equates to no interest payments. Given the risk profile of an income bond, it is usually only issued by companies having significant financial difficulties (usually in bankruptcy reorganization), and it is bought by investors with a high tolerance for risk.
The interest paid by this type of bond can be tied to total entity earnings or to specific projects. If the bond terms indicate that interest is cumulative, then interest will accumulate during non-payment periods and be paid at a later date when income is available for doing so. Non-payment does not necessarily mean that the issuing entity is in default. A cumulative interest feature reduces the risk for the investor.
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Example of an Income Bond
A struggling manufacturing company, Midwest Steel Corp., needs to raise $10 million to restructure its operations. Because of its poor financial performance, investors are hesitant to buy traditional bonds from the company due to the risk of default on interest payments. To make the offer more attractive, Midwest Steel issues income bonds instead.
Each income bond has a face value of $1,000, a maturity of 10 years, and an interest rate of 6%. However, unlike traditional bonds, Midwest Steel is only required to pay interest if it earns sufficient income. If the company has no net income in a particular year, it is not obligated to make the interest payment.
An investor named Jane buys 50 of these bonds, investing $50,000. Over the next three years, Midwest Steel posts losses and makes no interest payments. In year four, the company turns a profit, so it pays 6% interest to bondholders, and Jane receives $3,000 in interest that year (6% of $50,000). She continues to receive interest in profitable years, and at the end of 10 years, she receives her original $50,000 principal, regardless of how many interest payments were made during the bond’s life.