What Is a Discount Bond?
A discount bond is a bond issued or trading in the secondary market for less than its par—or face—value. When a bond trades significantly below its par value, particularly at 20% or more, it’s known as a deep-discount bond.
Key Takeaways
- A discount bond is issued or trades for less than its nominal or par value.
- Distressed bonds trading at a deep discount can offer attractive yields, often indicating higher risks, especially related to issuer default.
- Discount bonds reflect market sentiments regarding the issuer’s financial health and future profitability.
Understanding Discount Bonds
Most bonds start with a par value, typically $1,000, entitling the holder to this amount at maturity. However, they often change hands in the secondary market before maturity, where bonds traded below face value are termed as discount bonds. For example, a bond with a $1,000 face value now sold for $950 is a discounted bond.
Since bonds are debt securities, bondholders receive interest payments—also known as coupon payments. These coupons are usually semiannual but can vary to monthly, quarterly, or annually. Discount bonds can be pursued by both individual and institutional investors, with specific regulations for the latter. An example of a discount bond is U.S. savings bonds.
Interest Rates and Discount Bonds
There is an inverse relationship between bond yields and bond prices. When interest rates in the economy rise, existing bonds’ prices fall and may drop below their face values, making them discount bonds. Conversely, if interest rates drop, the value of existing bonds may increase.
For instance, if interest rates hike after purchasing a bond, its value dips due to a lesser return compared to new, higher-rate bonds. Hence, to sell the bond, the price is often brought down, turning it into a discount bond. This lower price reflects its relative lower yield in contrast with current, generally higher yields.
Using Yield to Maturity (YTM)
Investors can recalculate older bond prices in current market terms using the Yield to Maturity (YTM). YTM is a comprehensive measure considering current market price, par value, coupon rate, and maturity time. Despite its complexity, various online calculators aid in determining a bond’s YTM efficiently.
Default Risk with Discount Bonds
Buying a discount bond carries significant potential for price appreciation, considering there is no default. Long-term bonds, however, hold higher risks of issuer defaults, precisely reflected by noticeable discounts, signaling financial distress. As compensation for this risk, investors get these bonds at lower prices.
Distressed and Zero-Coupon Bonds
Distressed bonds are at high risk of default and often trade at deep discounts, attracting speculative investors. These bonds usually don’t promise full or timely interest payments.
Zero-coupon bonds are deep-discount bonds sold significantly below par value and steadily appreciate towards face value at maturity, making a single full-face amount payment without periodic coupons. This makes them attractive for long-term, speculative investments.
Pros and Cons of Discount Bonds
Pros
- High potential for capital gains since bonds are below face value, sometimes deeply discounted at 20% or more.
- Investors receive regular interest payments unless holding zero-coupon bonds.
- Availability in both short-term and long-term maturities, catering diversely to investor portfolios.
Cons
- High-risk indication due to potential issuer default, declining dividends, and investor reluctance in buying such debt.
- Greater financial distress risk in longer-termed bonds reflected through deeper discounts.
- Buying deeply discounted bonds mirrors the company’s severe financial strain and higher risk of defaulting on obligations.
Real-World Example of a Discount Bond
As of March 28, 2019, Bed Bath & Beyond Inc. (BBBY) had a bond trading at a discounted price. Below are the bond’s details:
- Issue: BBBY4144685
- Description: BED BATH & BEYOND INC
- Coupon Rate: 4.915%
- Maturity Date: 08/01/2034
- Yield at Offering: 4.92%
- Price at Offering: $100
- Coupon Type: Fixed
By March 29, 2019, the bond’s price had dropped to $79.943. This deep discount, despite offering a higher yield than a 10-year Treasury note’s 2.45%, indicates BBBY’s financial distress. Persistent price drops and variable high yields, some up to 7%, substantiated market-perceived risks about BBBY’s financial stability.
Related Terms: par value, coupon rate, bond yield, premium bond, corporate bonds, distressed bonds.
