The IMF's Statistical Systems in Context of Revision of the United Nations' A System of National Accounts

14 Classification of Transactions in Zero-Coupon Bonds, Junk Bonds, and Indexed Bonds in the Balance of Payments

Vicente Galbis
Published Date:
September 1991
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Robert McColl

Since publication of the fourth edition of the IMF's Balance of Payments Manual (BPM) in 1977, the international capital markets have seen a burgeoning in the variety of financial instruments in use. Either because these instruments did not exist or were not of significance before 1977, they were not expressly mentioned in the BPM. This paper will examine three such instruments—zero-coupon bonds, junk bonds, and indexed bonds—for which the application of the BPM's recommendations with regard to the classification of transactions may not, at first glance, be clear-cut.

Section I of the paper briefly reviews the BPM's recommendations for the separation of transactions in financial instruments into those that constitute the extension or redemption of principal and those that constitute income payable for the provision of that capital. Sections II-IV deal, in order, with each of the new financial instruments listed in the previous paragraph, highlighting any unusual features of those instruments and identifying and applying the relevant recommendations as outlined in Section I. Section V brings together the observations about the nature of the instruments chosen for analysis and concludes that they can be accommodated within the framework of the BPM.

I. Income and Principal in the Balance of Payments

Transactions in foreign financial assets can be thought of as having three possible components: (1) the extension of principal and its subsequent repayment;1 (2) income; and (3) capital gains and losses (from the realization of valuation changes).

Together, components 1 and 2 reflect the exchange of a sum to be delivered in one or more installments, the principal, against another sum to be delivered in one or more installments, covering the principal plus the positive or negative income over that principal. Thus, the principal refers to the amount originally advanced by the creditor and, with the exception of perpetual bonds, is equal to the sum required at maturity to redeem the debt. Any additional (positive or negative) amount expended at the time the debt is redeemed, at maturity, constitutes income generated by the asset.

Investment income is generally regarded as a gain or recurrent benefit derived from the ownership of capital. In the balance of payments, it is income derived from the ownership of foreign financial assets.

Component 3 reflects two transactions, a purchase and a sale, at different prices. Capital gains and losses present the realization, through a change in ownership, of a change in the value of a financial asset because of general interest rate changes, a change in the credit-worthiness of the issuer of the debt, and so on. Such capital gains should not be confused with income, which accrues because of the passage of time. Unrealized valuation changes, including write-offs, although of importance in generating balance-sheet data, do not represent transactions and are omitted from the flow accounts.

Any debt security will provide a return that can be considered to have three components: an income component to compensate the owner of the capital for providing its use to others; an inflationary component to compensate for any decline in purchasing power of the capital advanced; and a risk component to compensate for exposure to the possibility of a failure by the debtor to return the funds advanced. All such compensations form the return or income on the security.

It would seem that the identification of principal is easily made. Once a credit has been extended, that amount continues to reflect the principal. For example, where securities are issued “at a value different from the stated fixed sum that their holder has the unconditional right to receive when the obligations mature” (BPM, paragraph 293)—that is, the principal—that difference is to be regarded as income and recorded when payable. Such discounts or premiums might range from small adjustments to coupon bonds (to take account of minor fluctuations in the market interest rate between the time the prospectus specifying the coupon rate is issued and the bonds are sold), to large adjustments to those securities that bear no coupon and provide their holders with a return solely in the form of a discount.

When such instruments are traded after they have been issued, separating income from capital gains (losses) becomes more difficult. Then, any difference between the price at which the instrument was initially sold and the price at which it was purchased (at the time of issue or thereafter) does not represent income but a realized valuation gain (loss), to be recorded in the capital account.

In the following three sections the above general principles and specific recommendations will be applied to the three instruments chosen for analysis to determine the appropriate classification of transactions in these securities.

II. Zero-Coupon Bonds

Zero-coupon bonds are debt securities that pay no coupon interest during the life of the bond, so that the income is composed solely of the difference (or discount) between its redemption price and its issuance price. Such bonds, therefore, represent the extreme situation for discount income and, as described in the previous section, according to the BPM this discount is recorded as income at the time that it is due for payment. The principal is the value for which the bond is issued. At redemption (at maturity), the transactions will involve the repayment of principal (equivalent to the issue value) and the payment of accrued income (equivalent to the redemption price less the issue price). If the security is traded before maturity, the transaction price may include, in addition to accrued income, a realized valuation change for the seller of the asset. That valuation change will appear in the capital account by recording purchases and sales of the bonds at market prices.

An obvious problem in accounting for zero-coupon bonds is that, because the entire income is generated through the discount, the cost of providing the capital is not appropriately matched to the periods for which the capital is provided. Minor inconsistencies for discounts or premiums that represent adjustments to coupon issues become major distortions for zero-coupon bonds. Accruing the income over the life of the bond, as recommended in Chapter 3 of this volume, would eliminate the distortion.

III. Junk Bonds

Junk bonds, also referred to as high-yielding or speculative bonds, are debt securities that yield a significantly higher rate of return than top-grade bonds because these issues are perceived to be high-risk ventures.

A junk bond differs from other bonds in that the risk component of the rate of return is large compared with the other elements in that rate. Nonetheless, the composite rate is still income, just as high nominal interest rates drawn in periods of high real interest rates or of high inflation are income. The degree to which any element within the composite interest rate may be dominant is irrelevant. For example, in any economy there will be a wide divergence in the risk assessments awarded the various debtors in the capital markets. Government-guaranteed debt might be trading at interest rates substantially below a high-quality corporate or “prime” rate for similar maturities. The difference is in the magnitude of the risk component. New debtors to the market will pay considerably more than the prime rate, again because of the higher risk assessment associated with their issues. The junk bond represents an extreme in which the risk component is very large indeed.

To consider the exceptional risk component of the interest rate applicable to a junk bond as capital being returned to the investor would require all interest on all securities to be reassessed and a new notion of income to be derived to exclude that risk element. Some threshold level of risk would have to be set arbitrarily, above which interest payments might be deemed to represent capital repayments. It is not obvious what analytical usefulness would be derived from such an arbitrary allocation between income and capital. A similar exercise could be required to remove the inflationary element from income when inflation is high or volatile. Such redefinitions of the basic notion of income, however, are beyond the scope of this paper.

IV. Indexed Bonds

Indexed bonds are debt securities for which the redemption value or coupon payments (or both) are linked to a price index2 in order to protect the holders of the bonds against a depreciation in terms of purchasing power of the asset. These two types of indexing, of the redemption value or of the coupon payments, will be considered separately to facilitate their analysis.

Bonds whose coupon payments are indexed are essentially floating-rate bonds. The intention may be to accommodate only changes attributable to inflation, but the choice of the target may actually alter the income component by over- or undercompensating for inflation. It would appear, therefore, that bonds carrying indexed coupons should be treated like any other variable rate bond; that is, the coupon payments are considered to be income.

Bonds for which the redemption values are indexed are essentially discount bonds, except that the conventional discount bond has the redemption value expressed in money terms. The yield or rate of return expected from the bond determines the difference between the issue price and the redemption price. For indexed bonds, the issue price is known and the “stated fixed sum” that the holder has an unconditional right to receive is a monetary amount multiplied by an index. In other words, the discount rate is determined ex post.

For bonds that have the redemption value indexed, the issue price should therefore be recorded as the principal value for the bond, with the additional indexation payment payable at maturity being the discount part of the income. Of course, the considerations with regard to accrued income for deep-discount, zero-coupon, and other bonds will also apply to bonds with the redemption value bearing an indexed return.

However, whereas the application of compound interest rate formulas may be necessary in the calculation of accrued income for other bonds, the index will provide a direct and easily applied factor for compiling the discount or indexed income over the life of the bond.

Bonds bearing a combination of indexed coupons and redemption values resemble coupon bonds issued at a discount. Each element will be separately recorded in accordance with the above discussion.

V. Conclusions

From the analyses presented here, it would appear that the three financial instruments chosen for consideration do not exhibit any features for which the BPM does not make provision in its recommendations. The apparent novelty of each of the instruments discussed lies in the magnified significance of particular standard elements contained in the more regular instruments discussed in the BPM. Zero-coupon bonds emphasize the discount element of income to the exclusion of coupons; junk bonds emphasize the risk element contained in the interest yield on such securities; and indexed bonds simply match the rate of return, through either coupons or discounts, to some specified index in the hope of accurately setting the inflationary element in the interest rate.

Perpetual bonds or loans by definition do not call for repayment of principal.

Although indexed bonds are usually linked to a price index of one or more commodities, there are also other types of linkage, such as linkage to the exchange rate of a currency or a basket of currencies, or to the price of a basket of shares.

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