Introduction to Securitization

ACCRUAL BONDS AND ACCRETION-DIRECTED BONDS

Accrual bonds, also referred to as Z-bonds, are bond classes where for a specified period of time (refereed to as the lockout period) the bond coupon is accrued by adding the interest to the par value of the bond. The interest that is deferred during the lockout period is added to the accrual bond’s par value in a process called accretion. The deferred interest is then directed to a different bond class in the structure. This directed cash flow can either form the principal for an entirely new tranche or be combined with an existing tranche to smooth the cash flow profile. Bond classes created from the directed interest are called accretion-directed bonds.

The motivation for a structurer to carve up normal interest-paying bonds into accrual bonds and an accretion-directed class is that overall deal execution can be improved by either creating very stable bonds (which can be sold in the market at a lower yield than otherwise) or using the accreted interest to improve the profile of existing bond classes to make them more marketable (and ultimately have them trade at a lower yield than otherwise). The creation of an accrual bond class which has a long duration has a natural clientele: It appeals to investors such as defined benefit pension plans and insurance companies seeking a fixed income security to satisfy their longer-dated liabilities. Moreover, making them even more attractive to such investors, these bond classes eliminate reinvestment ...