What is Discount Bond?

A discount Bond is defined as a bond that is issued for less than its face value at the time of issuance; It also refers to those bonds whose coupon rates are less than that of the market interest rate and therefore trades at less than its face value in the secondary market.

Assume a bond is sold in the market for USD 80. But at the end of maturity, the bond pays USD 100. The bondBondBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more looks cheap, but the issuer might be in financial trouble. Hence there will not be any interim or coupon payments. And there will be a capital gain at the end of maturity. They can be purchased and sold by both individual and institutional investors. However, institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more must adhere to specific regulations for the purchase and sale of discount bonds. U.S. savings bond is one of the examples of a discount bond.

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Types of Discount Bond

The following are types of discount bonds.

#1 – Distressed Bond

  • More likely to default.Trades at a significant discount to face value,Such bonds may or may not make interest payments. Or the timings of payment might be delayed. Hence investors in such bonds are speculating. So with a minimum price of the bond and even minimum interest from these bonds, make them a high yielding bond.

#2 – Zero-Coupon Bond

  • Zero-coupon bondsZero-coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more don’t pay any coupons during their tenure.It is a type of deep discount bond where they might be issued at a discount of even 20%, especially when the maturity period is high.Though there may not be any interest payments, the price of the bond rises steadily towards the end of the term. This is because the bonds are paid in full at maturity.

Example of Discount Bond

Let’s take an example of a discount bond.

Consider a bond listed on NASDAQ, which is currently trading at a discount. The coupon rate of the bond is 4.92. The price at the time of issuance of a bond is $100. The yield at the time of issuance is 4.92%. The current price is $79.943, which clearly shows that the bond is trading at a discount. Though the coupon rate is high compared to the yield on a 10-year Treasury noteTreasury NoteTreasury Notes are government-issued instruments with a fixed rate of interest and maturity date. As a result, it is the most preferred option because it is issued by the government (therefore, there is no risk of default) and also gives a guaranteed amount as a return, allowing the investor to plan accordingly.read more, still the price of the bond is discounted. This is because the company has lower earnings and negative cash flowsNegative Cash FlowsNegative cash flow refers to the situation when cash spending of the company is more than cash generation in a particular period under consideration. This implies that the total cash inflow from the various activities under consideration is less than the total outflow during the same period.read more. This increases the default risk.

The yield may also trade higher than the coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more. It happens when the price is much lower than the face value. This clearly shows that it is a deeply discounted bond. Similarly, when the credit rating of the company is reduced by a credit rating agency, then investors start selling in the secondary market at high volumes. This reduces the fair value of bonds, thereby increasing the yield.

Yield to Maturity (YTM) of Discount Bonds

YTM is the IRR – internal rate of returnIRR - Internal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more of the investment in a bond, if an investor holds the bond until maturity with all payments made as per scheduled and reinvested at the equivalent rate. To understand the Yield to MaturityYield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond’s returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more of a discount bond, it is better to start with bonds that do not pay a coupon. Then some of the more complex issues with coupon bonds become understandable.

YTM of a discount bond is calculated as

  • n = number of years to maturityFace value = bond’s maturity value

YTM is the rate an investor earns by reinvesting all coupon payments received from the bond until the bond’s maturity date at the same rate. The PV (present value) of all future cash inflows is the bond’s market price. There is no direct method of calculating discount rates. However, there is a trial-and-error method that can be applied on YTM until the present value of the stream of payments equals the bond’s price.

Interest Rates and Discount Bonds

Bond prices and bond yieldBond Prices And Bond YieldThe bond yield formula evaluates the returns from investment in a given bond. It is calculated as the percentage of the annual coupon payment to the bond price. The annual coupon payment is depicted by multiplying the bond’s face value with the coupon rate.read more share an inverse relationship. When there is an increase in interest rate, there will be a decrease in the price of a bond and vice versa. A bond with lower interest or coupon rate than the market rate would possibly be sold at a price lower than its face value. This is due to the availability of similar bonds or other securities with a better return.

For example, When the interest rates rise after the bond is sold in the market. The value of the newly sold bond would decrease as the market interest rate is higher. If the buyer of the bond wants to sell the bond in the secondary market, then they have to offer at a lower price to affect the sale. When the prevailing market interest rates rise to a point where the value of a bond falls below its face value, it becomes a discount bond.

A very important relationship can also be derived from this formula. In the described example, coupon rate (r) is greater than YTM. If r<YTM, the bond price will be less than face value, while if r=YTM, the bond price will be equal to its face value. This also suggests an inverse relationship between YTM and bond prices.

Simulating two more combinations of coupon rate and YTM yields the following results:

** This graph looks like a straight line since we have used only two data points, but in reality, when we consider more data points, it converges to look more like an exponential graph.

Advantages

Some of the advantages are as follows:

  • When an investor buys the investments at a discounted price, it offers a greater opportunity for capital gains. However, this advantage must be compared to the disadvantage of paying taxes on such capital gains.BondholdersBondholdersA bondholder is an investor who buys or holds a government or corporate bond.read more receive interest in regular intervals (unless it’s a zero-coupon bond), -usually semi-annually.They are offered with long-term and short-term maturities.

Disadvantages

Some of the disadvantages are as follows:

  • It indicates the possibility of an issuer’s default, falling dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, or reluctance of investors to purchase the bond.The risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more is higher with long term discount bonds.Deeper discounted bonds indicate the financial distressFinancial DistressFinancial Distress is a situation in which an organization or any individual is not capable enough to honor its financial obligations as a result of insufficient revenue. It is usually the result of high fixed costs, obsolete technology, high debt, improper planning and budgeting, and poor management, and it can eventually lead to insolvency or bankruptcy.read more of a company and hence indicates a higher risk.

Conclusion

There are a few risks that need to be analyzed before investing in discount bonds. They are Interest Rate RiskInterest Rate RiskThe risk of an asset’s value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more, Credit RiskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, Inflation RiskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk.read more, Reinvestment RiskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity.read more, Liquidity RiskLiquidity RiskLiquidity risk refers to ‘Cash Crunch’ for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more. As investors always intend for a higher yield, they pay less for the bond, which has lower coupons compared to prevailing rates. Hence, to make up for low coupon rates, they would buy the bonds at a discount. A bond that is sold at a price significantly lower than face value, even with a discount at 20% or more, is the deep-discount bond.

This has been a guide to what is discount bond and its definition. Here we discuss the types of discount bonds along with the example, advantages, and disadvantages. You can learn more about investment banking from the following articles –

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