How does a Flat Income Bond Work?

When a bond is on default for its interest and principal, it will be traded flat. However, a flat income bond is a bond that has a quotation of a flat price and merges the concept of both flat and income bonds. No accrued interest is associated with a flat price. Periodically, certain bonds pay interest to investors that hold them; when there is a quotation of an instrument associated with interest, the investors either have a full-price quote or a flat price to reflect the interest paid. However, interest accrued on a specific bond doesn't change yield-to-maturity (YTM), which refers to a bond's value if left to its completion date. Typically, a flat bond's price quotation prevents anything that may mislead investors on the everyday full-price increment as an outcome of accrued interest.

On the other hand, an income bond refers to debt security or instrument that differentiates the principal on the debt and its interest payments. Here the borrowing company is obligated to pay off the principal amount of their debt. The interest payment, however, is subject to the earning level of the borrower. If the borrower is earning enough from the principal's returns, you will need to pay the coupon. If not, then you won't make any payment.

With these two understandings in mind, a flat income bond then defines and stipulates a debt payment, including the principal and the coupons or other interests within the last payment date.

Example of a Flat Income Bond

Company Alpha borrows a bond of $600,000 for ten years with a yearly annual payment. This flat income bond comes with an interest of 20% on every piece of income made.

  • Year 1: Company Alpha makes $40,000 income through the use of the bond. At the end of the year, Company Alpha needs to pay $64,000—$60,000 flat for the yearly principal and $4,000 for the annual interest.
  • Year 2: Company Alpha made $80,000 income. Its flat income bond repayment is $76,000.
  • Year 3: Company Alpha earned no income, so its flat income bond repayment is $60,000.

The payments continue until the end of the stipulated borrowing time.

Significance of a Flat Income Bond

A flat income bond serves a handful of uses for businesses and lenders:

  1. Debt security: A flat income bond serves as a security for lenders. Its rules and foundations are binding by a stipulated interest on payment as long as your business makes income from a project funded by the debt.
  2. Reduced liability: This is great for any business looking to reduce its repayment liability. If payment of interest is only limited to a fixed interest value on income made, your business would have a concentrated plan to help decide how much should be set aside as a debt service fund. (Debt service fund here refers to stored or set aside funds which one uses to pay off interests and principal on debts.)
  3. Easy capital: Borrowing capital is more straightforward since interest is set at a fixed value so long as you make an income from the use of the debt.