An income bond is a type of debt security in which the issuer promises to pay the bondholders interest, but only if the issuer has sufficient income to do so. If the issuer doesn’t generate enough income in a particular period, it can defer interest payments until it has sufficient income to make them.
This differs from conventional bonds, which obligate the issuer to make periodic interest payments regardless of their income or financial condition.
Income bonds are often issued by companies in financial distress or by those emerging from bankruptcy as a way of reducing their immediate cash obligations. Because of their conditional interest payments, they are considered higher risk than conventional bonds and may offer a higher yield to compensate for this additional risk.
At the bond’s maturity, the issuer is required to repay the bond’s face value to the bondholders, similar to other types of bonds. But again, interest payments are conditional on the issuer’s income. Note that any skipped interest payments are typically cumulative, meaning the issuer must catch up on them when they have sufficient income to do so.
As with all investments, investors considering income bonds should carefully consider the issuer’s financial condition and ability to generate income, as well as their own tolerance for risk and need for regular income from their investments.
Example of an Income Bond
Let’s take an example of a company that has recently emerged from bankruptcy.
Let’s call this company TechCo. As part of their restructuring plan, TechCo has issued income bonds to raise capital and manage their debt obligations. These income bonds have a face value of $1,000 and a 5% annual interest rate, with a maturity in 10 years.
However, unlike conventional bonds, the interest payments on these income bonds are not guaranteed. Instead, TechCo will pay interest to the bondholders only if it has enough income to do so.
Let’s say in the first year after the bonds are issued, TechCo has a successful year and earns substantial income. As a result, they make the full 5% interest payment to the bondholders, or $50 per bond.
In the second year, however, TechCo faces some challenges and its income falls. They don’t earn enough to cover the interest payments on the income bonds. Therefore, the bondholders do not receive an interest payment that year.
In the third year, TechCo’s business rebounds, and it earns enough income to cover the interest payments. Because the interest on these income bonds is cumulative, TechCo pays the current year’s interest plus the interest that was skipped in the second year. So, the bondholders receive a 10% payment, or $100 per bond, to catch up on the missed payment from the previous year.
This continues throughout the life of the bonds. At the end of the 10 years, TechCo is obligated to pay back the face value of the bonds, which is $1,000 per bond, regardless of its income in that final year.
This example illustrates the risk that income bondholders take on. Their interest payments depend on the issuer’s ability to generate income, which can fluctuate from year to year. However, it also illustrates the potential for higher returns, as the interest rate on income bonds is typically higher than on conventional bonds to compensate for the additional risk.