What Is an Accrual Bond?
Accrual bond pays no periodic interest, adding it to the principal instead so the whole amount is received at maturity. Removing the intermediate cash flows makes its price more sensitive to interest rate changes than any coupon-paying bond of the same maturity.
Take an ordinary bond and remove every payment before maturity. What remains is an accrual bond, and the removal changes its behaviour far more than it changes its arithmetic.
How it works
No coupons are paid. Interest accrues and is added to the outstanding principal, so the amount owed grows through the bond’s life.
Everything arrives at the end. One payment, at maturity, comprising the original principal plus all accumulated interest.
Which makes its duration equal to its maturity. A coupon bond’s duration is shorter than its maturity because some money comes back earlier; here, none does.
Why the sensitivity is extreme
Duration is the weighted average time to receiving money. With one payment at the end, that average is the full term — the longest it can possibly be.
And price moves scale with duration. A thirty-year accrual bond can move two or three times as far on the same rate change as a thirty-year coupon bond.
The compensating benefit is certainty. There are no coupons to reinvest, so the return if held to maturity is fixed at purchase regardless of what rates do in between.
A worked example
A twenty-year accrual bond bought at 30 with a face value of 100. No payments occur for twenty years.
The implied return is the rate that grows 30 into 100 over twenty years — roughly 6.2% compounded, and that number is locked at the moment of purchase.
A coupon bond at the same yield is not locked. Its stated yield assumes every coupon is reinvested at that yield, and if rates fall the actual realised return is lower.
Which is a genuine and underappreciated advantage. The accrual bond’s quoted yield is the return you get; the coupon bond’s is a projection resting on an assumption about the future.
Where the structure appears
Government strips. Dealers separate a conventional bond’s coupons from its principal and sell each piece as a standalone zero-coupon instrument, which is the largest and most liquid form of this.
Corporate zero-coupon issues. A company that wants to borrow without servicing cash interest until maturity, which suits a project generating nothing until completion.
Accrual tranches in structured deals. The Z-tranche of a mortgage security accrues while earlier tranches are paid down, absorbing prepayment variability on their behalf.
And that last case is the most dangerous version. A Z-tranche combines maximum rate sensitivity with uncertainty about when the accrual even stops, and it is a structure that has produced losses well beyond what its holders had modelled.
The original data
This site’s thirty-year fee measurement: 5 basis points costs 1.5% of the final balance, 20 costs 5.8%, 75 costs 20.2%, 150 costs 36.5%.
That table is compounding measured over exactly the horizon this instrument operates on. An accrual bond is the same arithmetic pointed the other way — a rate compounding in your favour, uninterrupted, for the full term.
And the price volatility is real: on this site’s series the largest bar is 2.338 against a median of 0.493, a 4.7-times ratio. A long-dated accrual bond amplifies whatever the rate market does, so an ordinary move in yields produces an unusually large move in price.
The tax problem
In many jurisdictions the accrued interest is taxable as it accrues. Income is assessed each year on an amount the holder has not received and cannot spend.
Which produces a cash-flow mismatch. A tax bill arrives annually against an instrument paying nothing until maturity, and the money to pay it must come from somewhere else.
Tax-sheltered accounts remove the problem entirely, which is why these instruments are held disproportionately inside pensions and similar wrappers.
The general rule is that this is a structure for a specific purpose. Matching a known future liability — a school fee, a defined pension payment — with a known future sum, inside a shelter. Held for any other reason, its properties tend to be liabilities rather than features.
How a strip is created
A dealer buys a conventional government bond and registers its individual payments as separately tradeable securities - each coupon date becomes one instrument and the final principal becomes another.
Each piece is then an accrual bond of its own maturity. A thirty-year bond with semi-annual coupons produces sixty short zeros plus one thirty-year zero, all backed by the same government.
And the process reverses. Reconstitution reassembles the pieces into the original bond, which is what keeps the prices of the parts consistent with the price of the whole - if the sum of the strips drifted away from the bond, somebody would trade one against the other.
That arbitrage is why strips are priced sensibly at all. They are not a separate market with its own supply and demand; they are a decomposition of one that already exists.
When it fails
The characteristic failure is holding one without a matching liability. The instrument is bought for its locked return, and then rates rise sharply. A thirty-year accrual bond can lose a very large share of its market value on a move that costs a coupon bond a fraction of that, and the holder who needs to sell realises the full loss. The locked return was always conditional on holding to maturity — that condition is the entire basis of the guarantee, and it is the condition most likely to break when the price has moved.
A second failure is ignoring the tax on phantom income, which is due whether or not cash arrives.
A third is underestimating the price sensitivity. These move far more than the maturity alone suggests.
A fourth is holding an accrual tranche without understanding prepayment, where the accrual period itself is uncertain.
And a fifth is treating the credit risk as reduced. Nothing is received until the end, so the issuer’s survival matters for the whole term rather than being partly recovered through coupons.
Related
Bond duration covers the measure this structure maximises. Bond convexity covers the second-order effect that is largest here. And corporate bond covers the credit exposure carried for the full term.
This is the purest interest rate instrument available. Strip out every intermediate payment and what is left responds to rate changes more violently than anything else of the same maturity — which makes it both the best hedging tool and the worst thing to hold by accident.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.