Income Bond

Updated on January 5, 2024
Article byWallstreetmojo Team
Edited byRaisa Ali
Reviewed byDheeraj Vaidya, CFA, FRM

Income Bond Definition

An income bond refers to a form of bond in which the bond issuer guarantees the payment of the bond’s face value at maturity. The interest to the bondholder is paid only when the company produces adequate profit.

The bond offering with non-obligatory interest payment is beneficial to the bond issuers since they don’t have to face legal consequences in case of default in interest payments. However, for the bondholder, the uncertainty about the bond yield attributes to the risk element. Furthermore, the covenantsCovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements.read more of such bonds vary with bond issuers.

Key Takeaways

  • An income bond refers to a financial instrument in which the issuer promises to repay the bond’s face value but has no guarantee about the interest payment.
  • Interest income depends on the net income generated by the bond issuing entity.
  • The unpaid interest is not pending, accumulated, or carried forward unless specified in the covenant, and covenants vary with bond issuers.
  • It helps businesses collect capital and uplift business operations with fewer obligations. In some countries, government entities also issue it to fund the government deficit.

Income Bonds Explained

Income bonds exemplify a type of bond which companies and governments use to borrow money from a group of investors by favoring them with guaranteeing face value at maturity and coupon payment triggered by the profit earned by the company. It implies that the interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more of investors is tied to the company’s financial performance. However, interest rates are usually higher than the market rate owing to the increased risk involved.

Income Bond

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The primary purpose of issuing it is to uplift entities on the verge of bankruptcy or facing solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more issues. Hence, such bonds are usually issued when a company is under severe financial duress or undergoing business restructuringRestructuringRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc.read more. Since there is no guarantee of interest payments, the main factor that may attract investors are the interest rate they offer. If the company couldn’t perform even after business restructuring, the investors will get back only the bond’s face value and earn no return in the form of interest.

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The bondholders in this scenario are comparable to the entity’s shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more since they are helping the entity grow without getting a regular income stream in return. In addition, the payment terms and structure may evoke comparisons to preferred shares of a company where the company is not obliged to make a dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more unless an adequate net income is generated every year. However, the process of unpaid interest getting accumulated in the books to pay later will not happen, unlike dividends in the case of preference sharesPreference SharesA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more.

NS&I Income Bond UK

National Savings and Investments (NS&I) is a state-owned savings bank in the United Kingdom. It is an executive agency of HM Treasury. They provide different savings instruments to attract funds from individual savers in the UK to fund the government’s deficit. NS&I attracts savers by offering savings products with tax-free elements on some products and a 100% guarantee from HM Treasury on all deposits.

NS&I Income Bonds are investments that pay the holder interest regularly. Users can start an account with amounts ranging from £500 to £1 million in total. Also, holders can withdraw at their discretion without receiving notice or penalty. The monthly interest is deposited into the holder’s bank or building society account. However, the NS&I income bond interest rate may vary with years, and the updated interest rate will be available on their official website.

Example

ABC Inc., a railroad company, has been facing financial difficulties due to competition. Apart from this, increased costs in logistics and have led the company to file for chapter-11 bankruptcy.

The executive management of the company has roped in a few large investors for an issue of US$50mn worth of income bonds with a tenure of 3 years. The money will be used for restructuring the company, paying off other outstanding dues, and cleaning up the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more while also providing the much-needed capital for the company’s future operations. The bond offers 7% interest at the time of issue to investors for their risk. The bond’s covenantsBond's CovenantsDebt covenants are formal agreements between different parties like creditors, suppliers, vendors, shareholders, investors, and a company, establishing limits for financial ratios such as leverage ratios, working capital ratios, and dividend payout ratios, which a debtor must refrain from breaching.read more also dictate that the company is not obligated to pay interest unless there is a generation of sufficient earnings from the company’s operating activities.

After the bonds issue, the company immediately sets the fresh capital to work. At the end of the current financial year, the company produces a loss of US$20mn and US$2mn for the second year and a profit of US$62mn in the third year. Since the company did not make a net income, the management can avoid the interest payment for the first two years. However, in the third year, the company managed to generate a profit and is now liable to pay the third-year interest to the bondholders. If the company could not generate enough surplus income to pay the interest throughout the tenure, the management pays only the holders’ principal amount.

Frequently Asked Questions (FAQs)

Are NS&I income bonds a good investment?

They are good options since the organization is backed by a government entity, HM Treasury, and offers a 100 percent guarantee on all deposits. National Savings and Investments (NS&I) is a UK state-owned savings bank. They provide various savings tools, including tax-free savings products, to collect cash from individual savers in the UK for the goal of funding the government’s deficit.

Do income bonds pay monthly?

Generally, the income stream is not monthly. In the case of income bonds, the initiation of interest payment depends on the profit figure in the quarterly or annual financial statement. If the profit figures are negative, there will be no interest payment to the bondholders. However, there are exceptions, like bondholders of the NS&I get monthly interest payments.

How do guaranteed income bonds work?

They are one-time investments that pay out a certain amount of money each month for a specified period. In addition, investors receive a promised fixed interest rate for their investment period.

This has been a guide to Income Bond and its definition. Here we explain how Income Bonds work along with examples including NS&I. You can learn more from the following articles –