How Does a Capital Appreciation Bond Work?

Capital appreciation bonds are a popular investment vehicle in the United States, often relied on by municipal authorities to fund public projects, such as parks, roads and sewer systems. These bonds carry unique risks and advantages from the perspectives of both the issuer and the investor and must therefore be approached with caution.

Definition

Issuers of conventional bonds pay the bondholder periodic interest. A bond sold for $100 and carrying a 10 percent interest rate, for example, would pay the bondholder 10 percent of $100 or $10 every year. The holder of a capital appreciation bond, however, receives no periodic payments. Instead, an amount that includes both the original sum invested as well the appreciation of this sum is paid at the end of the bond's life as a lump sum. A capital appreciation bond originally sold for $100 with 10 percent interest rate and one year total life, would pay the holder $110 after a year and cease to exist.

Advantages for Issuer

From the perspective of the issuer, issuing a zero coupon bond is the equivalent of a "buy now, pay nothing for X years" campaign you often see at retailers. This makes such bonds particularly attractive when the proceeds from bond sales must be invested in long-term projects that will yield no cash income for several years. Therefore, municipalities that invest in long-term projects such as toll roads that will eat up cash for years before appreciable payback love capital appreciation bonds. However, over-reliance on such bonds can result in disaster if the eventual large payments resulting from such bonds aren't properly planned and budgeted for.

Advantages for Investors

Capital appreciation bonds eliminate what is referred to as reinvestment risk. Assume you got a great deal and purchase a bond paying 12 percent annual interest for 10 years. Every year you will end up with cash corresponding to 12 percent of your initial investment and must do something with that money. If similarly attractive investment prospects dry up a few years after you buy the original bond, you'll be left wondering how to invest the coupon payments that begin to accumulate. In an environment of declining economic prospects and lower interest rates, you may inevitably be forced to invest these sums at lower rates. By eliminating coupon payments, capital appreciation bonds do away with this risk.

Drawbacks for Investors

On the other hand, capital appreciation bonds pose a problem for investors who rely on periodic interest payments to pay for living expenses. Retired investors are often in such a situation and may find themselves strapped for cash if they invest large sums in capital appreciation bonds with far maturities. One way to overcome this issue is to hold a varied portfolio of capital appreciation bonds, so that some of them mature every year. These maturing portions of a carefully constructed portfolio can replicate the coupon payments of a conventional bond. Of course, structuring such a portfolio will require investing substantial time and effort to locate multiple bonds and may be infeasible for some bondholders.