Understand Deep Discount Bond.

Deep discount bonds, as the name suggests, are bonds that are sold at a significant discount to their face value. However, they also offer lower interest rates compared to other types of bonds. In this article, we will explain the concept of deep discount bonds, provide examples, and discuss their advantages and calculation methods.

 

 What is a Deep Discount Bond?

 Deep discount bonds are bonds that are sold at a price more than 20% lower than their face value. It has a higher yield than other fixed-income securities of a similar nature. The lower rate of interest and higher yields of these bonds is because the issuers are not that credible, and their ability to pay principal and interest on time is quite low. 

 However, zero coupon bonds are an exception as they will trade at deep discounts even though issuers have high credit ratings. This is because of the nil interest component and rising yield as the bond reaches closer to maturity.

 How Do Deep Discount Bonds Work?

 Deep discount bonds trade at a value that is quite lower than the par value of other fixed-income securities. Issuers offer discounts of at least 20% on the face value of these bonds because of two reasons. Firstly, deep discount bonds come at lower coupon rates than other bonds. Secondly, the credibility of issuers is not that great. There is an element of risk in these bonds, and discounts are offered to make them more lucrative. The higher the risk on these bonds, the higher will be the discounts offered on them. A zero-coupon bond is like a deep discount bond as it does not come with any interest. Discounts offered on zero-coupon bonds serve as interest for prospective investors. 

 

Calculation of Deep Discount Bonds

 

You can compute the price of these bonds using the following formula: 

 

P = F/ (1+r) ^h; 

Here, P implies price of deep discount bonds. 

F is its face value. 

r is the discount rate that issuers offer due to underlying risk factors; and 

h is the bond’s holding period. 

 

Example of Deep Discount Bond

 

Let’s understand the working of discount bonds with the help of an example: 

 

Suppose you are holding a discount bond whose face value is Rs. 10,000 and which comes at a coupon rate of 10% per annum. The period left for the maturity of these bonds is 2 years. Using the formula mentioned above, we can calculate the price of the respective bond: 

Price = 10000 / (1+5%) ^4

= Rs.8,200. 

We must note that to maintain standards of coupon-bearing bonds, we have divided the rate of interest by 2 and multiplied the holding period variable by 2 as well. Therefore, if an investor buys this bond for Rs.8,200 and receives full face value at the end of the holding period of 2 years, his/her effective coupon or interest rate will amount to 10%. 

 

 

 

 

What are the Advantages of Deep Discount Bonds?

 

Here are some advantages of deep discount bonds: 

 

• There are chances of significant capital appreciation on the purchase of these bonds. If you hold these bonds till maturity, you are liable to receive face value, although you purchased them at low prices. Therefore, there is scope for huge capital gains. 
• These are simple modes of investment, and you do not require any assistance from underwriters or brokers. This saves brokerage and commission costs. 
• It is ideal for long-term financial goals as the maturity period of these bonds is more than 5 years. 
• The minimum investment on these bonds is quite low; therefore, it is open to all types of investors. 
• Moreover, the liquidity of these bonds is quite high, and you can easily trade them in secondary markets. 

 

What are the Disadvantages of Deep Discount Bonds?

 

Some cons of investing in deep discount bonds are as follows: 

 

• The credit risk profile of issuers is always a matter of concern, and there is quite a high possibility of default. 
• Some bonds, like zero coupon bonds, are not fixed-income securities. You will not have the luxury of getting recurring income.  
• Capital gains arising from these are subject to taxation. It may negate all or some of the gains that one has made. 

 

Deep Discounts vs Zero Coupon Bonds

 

Some differences between deep discount bonds and zero-coupon bonds are as follows:

 

Parameter	Deep Discount	Zero-Coupon
Interest	These bonds come with an interest or coupon, which borrowers must pay periodically.	As the name suggests, these do not come with any interest or coupon.
Taxation	The difference between face value and subscription price is subject to taxation, and TDS is deducted.	In zero-coupon bonds, only the capital gains are subject to taxation.

 

 

Final Word

 

Deep discount bonds are a popular investment option due to their potential for significant capital growth. However, as they carry a high level of risk, investors must carefully analyze the market before investing in them.