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 bond 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 investors 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.
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 bonds 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 note, still the price of the bond is discounted. This is because the company has lower earnings and negative cash flows. This increases the default risk.
The yield may also trade higher than the coupon rate. 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 return 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 Maturity 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.
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YTM of a discount bond is calculated as
- n = number of years to maturity
- Face 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 yield 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.
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.
- Bondholders 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.
Some of the disadvantages are as follows:
- It indicates the possibility of an issuer’s default, falling dividends, or reluctance of investors to purchase the bond.
- The risk of default is higher with long term discount bonds.
- Deeper discounted bonds indicate the financial distress of a company and hence indicates a higher risk.
There are a few risks that need to be analyzed before investing in discount bonds. They are Interest Rate Risk, Credit Risk, Inflation Risk, Reinvestment Risk, Liquidity Risk. 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 –