How Does a Capital Appreciation Bond Work?

by C. Taylor


Municipal Securities

Capital appreciation bonds are considered municipal securities, because they are backed by local governmental agencies that impose restrictions on their issuance. These restrictions vary between municipalities but may limit what companies can issue capital appreciation bonds and how much debt may be held by the company. The backing of a local government makes capital appreciation bonds more attractive to investors, because the backing reduces the risk associated with the investment. The greater security increases demand for the bonds and allows small businesses to offer them at a lower interest rate than would be justifiable on a riskier investment.

Principle Amount

The principle amount of a capital appreciation bond is the investor's purchase price, which represents the original loan amount that must be repaid. The purchase price of a capital appreciation bond is greatly discounted from the bond's ultimate payout. Only the principle amount is counted toward the company's total debt. This benefit potentially allows the business to issue more bonds and subsequently receive greater working capital.

Par Value

A capital appreciation bond's par or face value is the amount eventually paid back to an investor. The par value is typically set at either $5,000 or $1,000 per bond but is not redeemable until the maturity date. The difference between the purchase price and the payout at maturity is the investor's return on investment. If an investor needs to sell back the bond before the maturity date, he does so with a penalty, which sometimes results in a negative return on investment.

Calculating Annual Interest

Annual compound interest is accrued on a capital appreciation bond up until the maturity date. The principle plus this accrued interest exactly equals the par value of the bond. Therefore, the annual interest rate paid fluctuates with the investor's original purchase price. Small businesses can calculate the interest rate they are paying by reversing the compound interest formula. Dividing the par value by the purchase price gives you the overall multiplier. Taking the nth root of this overall multiplier -- where n is the number of years until maturity -- gives you the annual multiplier. Subtracting 1 from this annual multiplier gives you the interest rate in decimal format. As an example, for a $5,000, 10-year bond purchased at $3,000, divide 5,000 by 3,000 to get 1.667. Take the 10th root of 1.667 to get 1.0524. Subtract 1 to get the annual interest rate of 0.0524, or 5.24 percent.

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