What Is a Deep-Discount Bond?
A deep-discount bond is a bond that sells at a significantly lesser value than its par value. In particular, these bonds sell at a discount of 20% or more to par and has a yield that is significantly higher than the prevailing rates of fixed-income securities with a similar profiles.
These high-yield or junk bonds tend to have low market prices due to underlying concerns about the issuers ability to repay interest or principal on the debt. This is not always the case however, as zero-coupon bonds will often begin trading at a deep-discount even if the issuer is very highly rated in terms of credit quality.
- A deep-discount bond trades at a market price that is 20% or lower than its par or face value.
- These discounts may reflect underlying credit concerns with the issuer, increasing the yields on these bonds to junk level as the risk of default increases.
- Zero-coupon bonds will also be issued at a deep-discount, even if the issuer is of the highest credit ratings, since these bonds do not pay coupons and will increase in value as they approach maturity.
Understanding Deep-Discount Bonds
When a bond matures, the investor is repaid the full face value of the bond. A bond can be sold at par, at a premium, or at a discount. A bond purchased at par has the same value as the face value of the bond. A bond purchased at a premium has a value that is higher than the par value of the bond. Over time, the value of the bond decreases until it equals the par value at maturity. A bond issued at a discount is priced below par. A type of discount bond traded in the markets is the deep-discount bond.
A deep discount bond will typically have a market price of 20% or more below its face value. An issuer of a deep discount bond may be perceived to be financially unstable. The bonds issued by these firms are thought to be riskier than similar bonds and are, thus, priced accordingly. Junk bonds are examples of deep-discount bonds. Bondholders may also find themselves holding deep-discount bonds when the credit rating of the issuing company is suddenly downgraded.
A bond may also be issued at a significant discount if the initial coupon rate on the bond is offered at a significantly lower than the going interest rate in the market, making it less attractive to investors who can find better interest rates elsewhere. Since the price of a bond is inversely related to interest rates, an increase in interest rates will mean that the coupon rate of existing bonds is not on par with newer bonds issued at the higher interest rate. Holders of these lower coupon bonds will, therefore, see the value of their bonds fall. The decrease in value reflects the fact that the prevailing interest rates are higher than the coupon rates on the bond. If interest rates increase high enough, the value of the bond may fall so far that it is offered at a deep discount.
Deep-Discounts and Zero-Coupon Bonds
A deep discount bond does not have to pay coupons, as seen with zero-coupon bonds. Some zero-coupon bonds are offered at a deep discount, and these bonds do not make periodic payments to bondholders. The yield on these bonds is the difference between the par value and the discounted price. This means that the price of zero-coupons will fluctuate more than bonds that provide periodic interest payments. All zero-coupon bonds are not deep-discount bonds; some are original issue discount (OID) bonds. For example, an OID bond may be one issued at $975 with a $1,000 par value, and a deep-discount bond may be one issued at $680 with a $1,000 par value.
Deep-discount bonds are typically long term, with maturities of five years or longer (except for Treasury bills which are short-term zero-coupon), and are issued with call provisions. Investors are attracted to these discounted bonds because of their high return or minimal chance of being called before maturity. Issuers seek the least cost method of raising capital through debt. Deep discount bonds appreciate faster than other types of bonds when market interest rates fall and depreciate faster when the rates rise. If interest rates increase in the economy, the existing bonds will carry lower interest payments and, thus, a lower cost of debt to the issuer. It will, therefore, be in the issuer’s best financial interest to not call the bonds.