What is a Discount Bond?

Though equity and debt securities are issued to raise money, they differ by structure. Unlike equity, debt securities have prespecified principal repayment and coupon payment schedules. Bonds are among the well-known debt securities.

Bonds are first issued in the primary market by corporations or governments. Then, existing bonds are traded in the secondary market. The price at which the bonds are traded in the market may not match their face value.They may trade at a value above or below their face value. Depending on at which prices the bonds are traded, it can be decided whether the bond is a discount bond or a premium one.

This article guides on the meaning of discount bonds, its example, why a bond sells at discount, and the pros and cons of investing in discount bonds.

About Discount Bond

A Discount bond is a fixed-income security issued at a lower price than face value or traded in the secondary market at a price less than its par value, or both. Though discount bonds are issued or sold at discount, they are repaid at par value at maturity.

Bonds are among the financial securities which are highly traded in the secondary market. Plenty of factors affect the market, and changes in market conditions tend to alter bond prices. The bonds have fixed interest rates. A bond is referred to as a discount bond when market interest rates are higher than the interest rates offered by a bond. In such scenarios, the price of that bond depreciated.

For example, if a bond with a face value of Rs. 1000 is issued at Rs. 980, then the bond is considered a discount bond. Moreover, if the bond with a face value of Rs. 1000 provides 5% coupon rates. If prevailing interest rates in the market increase to 7%, the price of the bond will drop as the market offers more return than this bond. This discounted price can somewhat balance out the lower rates. Though a discount doesn’t guarantee better returns, discount bonds are more concerned with discounted prices.

Popularly, there are two types of discount bonds. One is ‘Zero-coupon bonds’ and another is ‘Distressed bonds’. Zero-coupon bonds, as the name implies, do not offer periodical coupon payments. Such bonds are issued at a significant discount, with a discount of 20% or more for the long-term, and repaid at par on maturity. The price of such bonds gradually rises till maturity.

Distressed bonds are another type of discount bond. Distressed bonds are also issued at a significant discount as compared to par value. Though, the issuer may or may not make timely coupon payments. Although, there is no guarantee of coupon payments. Most of the time, risk-loving investors purchase such bonds.

The risk involved in discount bonds is higher as compared to other bonds. Aggressive investors prefer to invest in such bonds with the expectations of higher returns. Discount bonds are available to purchase for individual and institutional Investors.

Why does a bond sell at a discount?

A bond tends to trade at a lower price than its par value when interest rates prevailing in the market are higher than the coupon rate offered by the bond. The demand for such bonds will decrease as investors willing to get higher returns will get less attracted to the bond offering lower interest rates than the market. Lower demand will lead to reduced bond prices. To provide the investors with sufficient return, bonds are traded at discount. Investors buying the bonds at a lower price are at advantage, as the repayment will be done at par on maturity.

Another reason for bonds selling at discount can be high risk. A lower credit rating score of the issuer is one of the indicators of lower creditworthiness. The fear of default by the issuer makes the bond less attractive to the investors. To compensate for the fear, the bonds may be sold at discount.

Pros and Cons of investing in discount bonds

• Pros

  One of the primary benefits of discount bonds is the higher yield for investors. The investors purchase bonds at a lower price than the face value of the bond, yet repaid with the par value at the maturity. Some of such bonds are even sold at a 20% or more discount. The lifespan of discount bonds can vary from less than a year to long-term i.e. 10 years or more than that.

  Discount bonds have a higher potential for price appreciation if the issuer doesn’t default. Except for zero-coupon bonds, all other bonds regularly pay interest at the pre-specified intervals.

• Cons

  Higher returns largely come with a higher amount of risks. Bonds trading at a discount hint at a high-risk element involved in the bond. It indicates perceived fear among investors, of default by an issuer, for regular interest payment or principal repayment at maturity.

  To sum up, discount bonds are bonds with lower market value against face value. Since a bond is a fixed-income security, the lender pays interest periodically and principal at maturity. Discount bonds provide higher returns as the issuer pays the face value of the bonds at maturity. Though, the amount of risk involved is usually higher in the case of discount bonds. The investors shall check the risk involved before getting lured by discounted bond prices.