Deep Discount Bond
A bond issued with a face value of $1500 which means the investor will be paid $1500 at maturity plus any interest. However, bonds can be sold before maturity which is bought by other investors in a secondary market. Bonds that are issued at a value lower than their face value can be termed as a Discount bond. Since bonds are a type of debt security, bondholders receive interest which is called coupons from the bond issuer either monthly, quarterly, semi-annually, or annually. For example, if a bond worth $500 is sold in the secondary market for $150 can be termed as a Discounted bond.
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What is a Deep Discount Bond?
A bond can be sold at par, premium, or discount. A bond purchased at par is the same as the face value of the bond whereas a premium is when a higher amount is paid or received than the par amount and a discount is when a lower amount is paid or received than the par value. A type of a discounted bond is a Deep Discounted Bond. Such a type of bond generally has a market price of 20% or more below the face value. An issuer will issue such a bond when they are not financially stable. Bondholders tend to find themselves holding such bonds when the credit rating of the company suddenly downgrades. Deep discount bonds can be bought by both institutional and individual investors.
A deep discount bond issuer will have not to pay coupons which can be also termed as a zero-coupon bond. They are usually higher risk bonds. The yield from these types of bonds is the difference between the par value and the discounted price. Due to this reason, the price of deep discounted bonds fluctuates more than normal bonds. Deep discounted bonds are usually for a long term with a maturity of five years and longer and also have call provisions. Due to their longer maturity and lesser chances of being called off the investors are attracted towards them. When the market’s interest rate falls the deep discounted bonds appreciate faster than any other bonds but also depreciate the fastest when the market’s interest rate rises. Zero-coupon bonds are also issued at a deep discount even if they have the highest credit rating since these bonds do not pay coupons and their value increases before maturity.
Advantages of deep discounted bonds
- Predictable returns: The return on the bond is already known which is the face value of the bond.
- Low investment: As the bond is bought at a discounted price its investment value is quite low and affordable.
- Long term financial goals: A deep-discount bond is a suitable option for long term finances since it has a maturity of after five or more years.
- Eliminates reinvestment risk: It reduces the condition of reinvestment in the same coupon bond at a lower interest which adversely affects the yield at maturity.
- Traded in the secondary market: Deep discount bonds can be purchased or sold in the secondary market before maturity.
- Minimum risk: If the investment is made with a verified and assured insurer then the risk can highly be mitigated.
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Disadvantages of deep discount bonds:
- Survival of the company: The maturity of the bond is very long so there will always be doubts regarding the survival of the company for such a long period of time.
- No regular income: There is no regular income as it is a zero-coupon bond, the yield is only received on maturity.
- Long maturity period: The maturity period is very long, the investor has to wait for a really long time to receive the yield. It can sometimes even go up to forty years.
- Tax: Annual income tax has to be paid on the interest which the investor will receive on maturity.
- Interest rate risk: If the interest rate of the bond falls the issuer will redeem the bond by using the call provision before the maturity date and at a lower price. this is also pre-mentioned at the time of issuance.
The features of the deep discount bond attract different types of investors. Those who like to take long term investment goal will be attracted towards it whereas those with short term goals won’t be. Depending on their investment objectives they decide whether to go for a deep discount bond or no.
Author -Sanjana Rau
About the author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.