What is a Deep-Discount Bond?
It is a classification of those bonds sold at a discounted price than their par value. These discount bonds are sold at a rebate of 20% or more to par. Not to mention, these bonds have a higher yield than the prevailing fixed-income securities rate with an identical profile.
Such junk bonds have poor market prices. It is because of the fundamental concern about the inability of the issuers to repay the principal or interest on the debt.
However, it is not the same in every scenario. Zero-coupon bonds often start trading at a discounted price even if the issuer’s credit quality is higher.
Note: Deep-discount bonds also comprise zero coupon bonds. These bonds do not pay interest rates to the holder.
Deep-Discount Bonds – Explained
When certain bonds mature, the total face value of the bond is repaid to the investor. A bond is usually sold at par, at discounted prices or premium.
A bond purchased at par and the face value of the bond both have the same value. When a bond is purchased at a premium, the value of the bond is higher than the par value of the bond. With time, the bond value scales down until it equals the par value at maturity.
A bond issued at discounted prices is valued below par. Such types of discount bonds exchanged in the markets are called deep-discount bonds. Usually, a deep-discount bond will have a market price of 20% or more above the face value.
Furthermore, those who issue such bonds are often assumed to be financially unsecured. Such discount bonds are considered riskier than similar ones and hence priced accordingly. The perfect example of a deep-discount bond is Junk bonds.
A bond can also be issued at a higher discount if the starting coupon rate on the bond is offered at a lower value than the ongoing interest rate prevalent in the market. Consequently, it makes it less compelling to investors who can get better interest rates elsewhere.
Although the price of a bond is connected with the interest rates, a rise in interest rates will state that the current bond coupon rate is not in sync with the newer bonds that are generated at a higher interest rate.
Holders of lower coupon bonds witness the downfall of their bonds. The drop in value shows that the prevailing interest rates are greater than the coupon rates on a bond.
Note: When the credit rating of the bond issuing company is suddenly demoted, bondholders are often left with deep-discounted bonds.
Example and Calculation of Deep-Discount Bonds
Here is an instance of a discount bond.
Assume that on NASDAQ, a bond is listed that is presently trading at a discount. The coupon rate for the bond is 4.92. The cost at the time of bond issuance is USD 100. The yield is 4.92%. The current price is USD 79.943. This show that the particular bond is trading at a discount.
Even though the coupon rate is higher than the yield on a given 10-year Treasury note, the Bond prices are still discounted. It is because the earnings of the company are lower. It boosts the default risk.
The yield can also trade higher than a coupon rate. It takes place when the face value is greater than the price. It clearly states that it is a discounted bond. Likewise, when a company’s credit rating suffers due to a credit agency, investors begin selling in high volumes in the secondary market.
Here is how you can calculate deep-discounted bonds:
P= F(1+r) ^h.
As per this formula:
P= Price of bond
r- Implied discount rate
H – Holding period
F – Face value
What are the Features of Deep-Discount Bonds?
Usually, a deep-discount bond has a market price of 20% or more than its face value. Here is the list of its extensive features:
Subtle Interest Rate fluctuations
Bond prices generally have an adverse connection with interest rates. It is because when the cost of borrowing money rises, bond prices decline to make it appealing to investors. A deep-discount bond that offers no periodic payments till maturity are highly sensitive to changes in interest rates. Compared to interest bonds that offer periodic interest payments, deep-discount prices tend to fluctuate more.
Maturity Period
A deep-discount bond is usually generated for a longer period of time; generally five years or longer, inserted with call provisions. A call provision inserted in the contract enables the bond issuing individual to buy the bond again during the holding period and retire the debt security before maturity.
Coupon Payments
Usually, a debt-discount bond offers very low coupon payments or sometimes no coupon payments to the bond holder in the entire hold period. Not to mention, the bondholder is reimbursed with the bond’s par value during maturity.
High Risk
A deep-discount bond-holder will not get any periodic interest payments. The pricing for these bonds is significantly low. However, there are crucial concerns about the credibility of the issuers. Zero-coupon bonds, however, are exempted from this feature.
Conclusion
Certain risks must be evaluated and considered before investing in a deep-discount bond. These risks include Credit Risk, Reinvestment Risk, Interest Rate Risk, Liquidity Risk, Inflation Risk, etc.
With such bonds, investors can lock in an increased rate of return for a sustainable amount of time. Not to mention, investors can also leverage the benefits tagged with such investments.