Capital appreciation bonds are fixed-rate securities purchased at a discount instead of at face value. Rather than paying interest to the investor throughout the life of the bond, the interest the investor earns is the difference between the face value of the bond and the purchase price. The borrower pays the investor the initial investment plus the accreted interest of the bond at maturity.
Capital appreciation bonds lock in the return on the investment since there are no interest payments the investor has to invest in the future. This could be a big advantage if interest rates drop after investors purchase the bond.
Example:
Suppose a borrower planned to raise capital for a project. Instead of selling standard fixed rate bonds in $5,000 increments with a 10-year maturity, it sells the capital appreciation bonds in $2,500 increments.
During the 10-year life of the bond, investors won’t receive any interest from the borrower . But when the bond reaches maturity, they’ll receive the full $5,000 face value.
Investors essentially earn an annual interest rate of 7.05% on their investments (or a total return of 50%) and receive the full amount all at once and not spread over the full 10 years.
The cash flow of capital appreciation bonds is different from typical fixed-income securities. Capital appreciation bonds don’t make regular ongoing interest payments; instead they pay the investor all of the interest earned on the maturity date.