Income Bond: What it is, How it Works, Debt Restructuring

What Is an Income Bond?

An income bond is a type of debt security in which only the face value of the bond is promised to be paid to the investor, with any coupon payments paid only if the issuing company has enough earnings to pay for the coupon payment.

In the context of corporate bankruptcy, an adjustment bond is a type of income bond.

Income Bond Explained

A traditional corporate bond is one that makes regular interest payments to bondholders and upon maturity, repays the principal investment. Bond investors expect to receive the stated coupon payments periodically and are exposed to a risk of default in the event that the company has solvency problems and is unable to fulfill its debt obligations.

Bond issuers that have a high level of default risk are usually given a low credit rating by a bond rating agency to reflect that its security issues have a high level of risk. Investors that purchase these high-risk bonds demand a high level of return as well to compensate them for lending their funds to the issuer.

There are some cases, however, when a bond issuer does not guarantee coupon payments. The face value upon maturity is guaranteed to be repaid, but the interest payments will only be paid depending on the earnings of the issuer over a period of time. The issuer is liable to pay the coupon payments only when it has income in its financial statements, making such debt issues advantageous to an issuing company that is trying to raise much-needed capital to grow or continue its operations.

Interest payments on an income bond, therefore, are not fixed but vary according to a certain level of earnings deemed sufficient by the company. Failure to pay interest does not result in default as would be the case with a traditional bond.

Debt Restructuring and Income Bonds

The income bond is a somewhat rare financial instrument that generally serves a corporate purpose similar to that of preferred shares. However, it’s different from preferred shares in that missed dividend payments for preferred shareholders are accumulated to subsequent periods until they are paid off.

Issuers are not obligated to pay or accumulate any unpaid interest on an income bond at any time in the future. Income bonds may be structured so that unpaid interest payments accumulate and become due upon maturity of the bond issue, but this is usually not the case; as such, it can be a useful tool to help a corporation avoid bankruptcy during poor financial health or ongoing reorganization.

Income bonds are typically issued either by companies with solvency problems in an attempt to quickly raise money to avoid bankruptcy or by failed companies in reorganization plans looking to maintain operations while in bankruptcy. To attract investors, the corporation would be willing to pay a much higher bond rate than the average market rate.

In the event of a Chapter 11 bankruptcy ruling, a company may issue income bonds, known as adjustment bonds, as part of its corporate debt restructuring to help the company deal with its financial difficulties. The terms of such a bond often include a provision that when a company generates positive earnings, it must pay interest. If revenues are negative, no interest payment is due.