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Discounted bond

Category — Bond Types
By Nikita Bundzen Head of North America Fixed Income Department
Updated January 15, 2025

What are Discounted Bonds

A discount bond is a type of debt obligation that is either issued or traded in the secondary market at a price lower than its par value. This situation often arises when the coupon rate of the bond is lower than the prevailing interest rates. In essence, the bond sells for less than its face value to attract investors who seek higher yields relative to other securities available in the market.

Similar to zero coupon bonds, which do not provide regular interest payments until maturity, discount bonds also offer the potential for capital appreciation. However, unlike zero coupon bonds, discount bonds may still make regular coupon payments, albeit at a lower rate than the current market interest rates.

/></p> <h2>Discounted Bonds Explained</h2> <p>A discount bond is a type of fixed-income security. It is issued by governments and companies that want to raise money. When an investor purchases a bond, they essentially become a creditor to the bond issuer, who, in turn, becomes a debtor. The bond's face value, also known as its par value, is the amount the investor pays to purchase the security. For example, if an investor pays $1,000 for a bond, its face value is $1,000.</p> <p>However, some bonds trade at a lower price than their face value. These bonds are known as discount bonds. For instance, if a bond with a $1,000 face value is currently selling for $950, it is considered a discount bond. Discount bonds can be bought and sold by both institutional and individual investors, though institutional investors must adhere to specific regulations when trading discount bonds.</p> <p>Discount bonds are often seen in the secondary market when the coupon rate is lower than the prevailing interest rates. As market interest rates rise, existing bonds with lower coupon rates become less attractive, causing their value to drop. This decrease in value makes them discount bonds. U.S. savings bonds are a common example of discount bonds.</p> <h2><strong>Why Bond Prices Fluctuate During Trading</strong></h2> <p>When a new bond is issued, it comes with a stated coupon rate that indicates the amount of interest bondholders will earn. For example, a bond with a par value of $1,000 and a coupon rate of 3% will pay annual interest payments of $30. However, bond prices in the secondary market fluctuate due to changes in prevailing interest rates.</p> <p>If the prevailing interest rates drop to 2%, the bond value will rise, causing the bond to trade at a premium. Conversely, if interest rates rise to 4%, the value of the bond will drop, making it trade at a discount. This fluctuation occurs because the yield to maturity (YTM) of bonds must align closely with the YTM of new bond issues to remain competitive in the market.</p> <p>The relationship between bond prices and YTM is inverse. When interest rates are higher than the bond’s coupon rate, bond prices must decrease below the par value, creating a discount bond, to ensure the YTM aligns with the current market interest rates. For instance, if market interest rates rise, existing bonds with lower coupon rates become less attractive, leading to a decrease in their trading price.</p> <p>On the other hand, if interest rates drop below the coupon rate, bond prices rise above the par value, resulting in premium bonds. During periods of falling interest rates, bonds will trade at a premium so that the YTM adjusts to the lower market rates. Conversely, rising interest rates will result in more bonds trading at a discount of their par value.</p> <h2>Advantages and Disadvantages</h2> <h3>Advantages</h3> <ol> <li> <p><strong>High Potential for Capital Gains</strong>. Discount bonds sell for less than their face value, offering the potential for capital gains when they mature at par value or when their market price increases.</p> </li> <li> <p><strong>Variety of Maturities</strong>. Discount bonds are available with both short-term and long-term maturities, providing flexibility for different investment strategies.</p> </li> <li> <p><strong>Interest Income</strong>. Investors may receive regular interest payments unless the bond is a zero-coupon bond, which does not make regular interest payments but is issued at a significant discount.</p> </li> </ol> <h3>Disadvantages</h3> <ol> <li> <p><strong>Higher Risk of Default</strong>. Deeply discounted bonds, also known as distressed bonds, may indicate a higher risk of issuer default or financial distress, posing greater risks to investors.</p> </li> <li> <p><strong>Credit Quality</strong>. The credit quality of the issuer is a crucial factor to consider, as lower credit quality can lead to higher risk.</p> </li> <li> <p><strong>Potential for Issuer Default</strong>. Discount bonds may suggest the issuer is experiencing financial difficulties, which could impact their ability to make interest payments and principal repayment.</p> </li> </ol> <h2>Default Risk</h2> <p>Default risk refers to the possibility that the bond issuer may fail to make interest payments or repay the principal amount at maturity. This risk is particularly relevant for discount bonds, which may signal that the issuer is experiencing financial distress or that investors expect future financial difficulties.</p> <p>The chances of a discount bond appreciating are reasonably high if the issuer does not default. Investors purchasing discount bonds at a lower price than their face value can receive the full face value upon maturity, realizing a capital gain. However, longer-term bonds, which can mature in 10 to 15 years or more, often carry a higher default risk compared to short-term bonds, which mature in less than a year.</p> <p>Investors are compensated for the higher risk involved with discount bonds by purchasing them at a discounted price. This discount provides a cushion against the potential risk of issuer default, falling dividends, or a general reluctance among investors to buy these bonds.</p> <p>Understanding the credit quality of the bond issuer is crucial when investing in discount bonds. While these bonds can offer attractive yields and the potential for capital gains, the higher risk of default must be carefully considered to ensure a balanced investment strategy.</p> <h2>Example</h2> <p>Let's consider a real example to illustrate how discount bonds work. The Coca-Cola is offering investors a <a href=discount bond with the following details:

  • Coupon Rate: 2.875%

  • Maturity Date: 05/05/2041

  • Yield at Offering: 2.9%

  • Price at Offering: $999.7 or 99.97% from face value which is equal to $1,000

  • Coupon Type: Fixed

On the date 12/12/2024, the Cbonds Estimation was showing the bond's price is $75.404, significantly lower than its original offering price of $999.7. The bond's yield has fluctuated, sometimes reaching as high as 5.35%, which further indicates that the bond is deeply discounted. The yield is much higher than the coupon rate, coupled with the bond's current price being significantly lower than its face value, highlighting the risk involved.

FAQ

  • Are discount bonds a good investment?

    Discount bonds can be a good investment for investors seeking capital gains and higher current yields compared to premium and other bonds. However, they often come with higher risk, especially if the issuer is in financial distress. Investors purchase bonds at a discount to take advantage of potential appreciation as the bond approaches its maturity date, but must carefully assess the credit quality and financial stability of the issuer. Investing in bond funds can help mitigate some of the risks associated with individual discount bonds.

  • What is the difference between a premium bond and a discount bond?

    A premium bond trades at a price higher than its face value because its coupon rate is higher than the current market interest rate. Conversely, a discount bond trades at a price lower than its face value because its coupon rate is lower than the prevailing interest rate. While premium bonds offer lower current yields due to their higher prices, discount bonds provide higher current yields due to their lower prices, presenting different opportunities and risks for investors in fixed-income securities.

  • Is a discount bond a zero-coupon bond?

    Not necessarily. A discount bond and a zero-coupon bond are different. A discount bond pays regular interest payments (coupon payments) and is sold at a lower price than its face value due to its lower coupon rate compared to the current market interest rates. A zero-coupon bond, on the other hand, does not make regular interest payments. Instead, it is issued at a steep discount and matures at face value, with the difference representing the interest earned. Both can be found in the primary market and have different tax implications for investors, particularly concerning paying taxes on accrued interest for zero-coupon bonds.

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