Income BondA bond that only promises the payment of its face value

If an investor wants to invest in a relatively safe investment, s/he will usually go for bonds.

Especially government bonds which most see as risk-free instruments.

Unlike stocks which can have volatile rates of returns, bonds typically have a fixed rate of return.

This is why investing in bonds is generally a safer move than investing in stocks.

A bond is typically a fixed-income instrument.

It represents a loan extended by an investor to a borrower (e.g. a private business, a bank, or the government).

The bond itself will include details of the loans as well as its payments (principal and interest).

Typically, the interest payments will follow a fixed rate.

For example, if a bond states that it will pay 6% interest annually, then the bondholder will receive 6% of the loan amount each year.

This makes bonds an attractive investment for investors who seek a source of fixed income.

However, there’s a certain type of bond that doesn’t really follow this structure. We refer to this type of bond as the income bond.

Unlike a typical bond, an income bond only promises the payment of its face value (principal investment).

Any other payments (e.g. interests) are not guaranteed.

Rather, they depend on how much the borrower earns.

In this article, we will explore what an income bond is.

What makes it different from other types of bonds?

How does it compare to other types of investments?

Why would an investor consider investing in an income bond?

We will try to answer these questions as we go along with the article.

What is an Income Bond?

An income bond is a type of bond that only promises the payment of its face value (principal amount).

Interest or coupon payments will depend on whether or not the issuing entity has enough earnings to pay for them.

No profit means no interest payments.

In a way, investing in an income bond is similar to investing in stocks in which the investor shares in the risk of the issuing entity.  

Given the risk profile of income bonds, the companies that are having financial difficulties (usually those undergoing bankruptcy reorganization) are the ones that typically issue them.

In addition, since they’re riskier than your typical bonds, investors with a high tolerance for risk are the ones that usually buy them.

The interest payments from income bonds may be tied to the issuing entity’s total earnings or its specific projects.

Also, an income bond’s terms may state that interest is cumulative.

In such a case, the interest will accumulate during non-payment periods.

Any accumulated interest will be paid at a later period if there is enough income to do so.

Having a cumulative interest feature reduces the risk on the part of the investor.

As you can see, income bonds deviate from traditional bonds in that they don’t offer a fixed income.

A traditional bond is one that makes regular interest payments to the bondholder or investor.

Income bonds are still bonds though in that upon their maturity, the principal investment is repaid (same with traditional bonds).

On top of carrying the risk of default, income bonds also carry the risk of not having returns if the issuing entity doesn’t earn a profit.

This makes them riskier than a traditional bond.

Income bonds are advantageous to the issuing entity since failure to make interest payments does not necessarily result in default.

The Purpose of Income Bonds

With how riskier income bonds are than traditional bonds, one would wonder why an investor would want to invest in them.

It seems like they only benefit the issuer of the bond, right?

Non-payment of interest doesn’t necessarily mean default in payment after all.

It’s true that income bonds are advantageous on the part of the issuer.

After all, the primary purpose of issuing them is to uplift companies that are facing financial difficulties, usually those on the verge of bankruptcy.

As such, you would typically see them being issued by companies that are experiencing severe financial duress or undergoing business restructuring.

The issuer of income bonds only has to pay interest when it makes sufficient profit.

This somewhat lifts the burden of having to pay interest no matter how well the company is performing.

For a company that is facing severe financial issues, lifting such a burden can go a long way.

Given how income bonds mostly favor the issuer, why would an investor want to invest in them?

Well, to make up for the added risk that income bonds carry, they often offer higher interest rates than traditional bonds.

The higher rate of return is usually enough to entice investors who do not mind the added risk that much.

Aside from that, an income bond may include a “cumulative interest” feature.

This feature reduces the risk on the part of the investor.

In a way, an income bond is a sort of hybrid between a debt and equity instrument (similar to preferred shares).

The issuer still has the obligation to repay the principal amount (just like any other bond).

However, any other payments will depend on whether or not the issuer is earning enough profit (similar to how dividends work with stocks).

Chapter 11 Bankruptcy and Income Bonds

In the event of a Chapter 11 bankruptcy ruling, the concerned company may opt to issue adjustment bonds (which are technically income bonds by nature) as part of its debt restructuring.

Adjustment bonds can help the company deal with its financial difficulties.

Just like with any other income bond, adjustment bonds include a clause in which the issuing entity has to pay interest if it generates positive earnings.

If the issuing entity does not earn a profit or worse, generates a loss, then it does not have to pay interest.

For example, let’s say that the NA company has recently filed for Chapter 11 bankruptcy.

As part of its debt restructuring, the company issued $30 million worth of income bonds that will mature in 3 years.

The income bonds have an interest rate of 8%.

However, the NA company will only have to pay such interest if it is able to generate sufficient profits from its operations.

In the first two years after the issuance of the income bonds, the NA company wasn’t able to generate any profits generating a loss of $12 million in the first year, and only manage to break even in the second year.

However, in the third year, the NA company was finally able to bounce back and earn a net profit of $18 million.

In such a case, the NA company does not have to pay interest in the first two years since no income was made.

However, since the NA company generated a profit in the third year, it will then have to pay interest, but only for that year.

If there is a cumulative interest clause, the NA company will have to pay for any accumulated interest too.