Deep discount bonds – Meaning and features

Bonds are debt instruments that are one of the suitable investment avenues for investors looking for stable income. Bonds come in various types based on their features. Deep discount bonds are one of those types where bonds are offered at a discount.

Let us discuss the meaning, features and calculations of deep discount bonds. Read further to know if this option meets your investment objectives.

What are bonds?

Bonds are debt financing instruments. They are also called fixed-income instruments, as they provide a fixed interest to investors at periodic intervals. Governments and corporations issue bonds to the public to raise funds in the form of loans.

Also read: Bond voyage: Unraveling the intrigue of Bonds

Depending on the interest rate and issue price, bonds are classified into different types like zero-coupon bonds, inflation-indexed bonds, deep discount bonds, floating rate bonds, etc.

What is a deep discount bond?

Before we delve into deep discount bonds, it is essential to understand the meaning of the two primary concepts of bonds – the face value and the issue price.

• The face value refers to the value at which the bond was created. It is the value that the issuer will pay the bondholder at the time of maturity.
• The issue price is the cost at which the bondholder purchases the bond.

• When the issue price = face value, the bonds are issued at par.
• When the issue price > face value, the bonds are offered at a premium.
• When the issue price < face value, the bonds are issued at a discount.

When bonds are issued at a significant discount, they are called deep discount bonds. The distinction between the face value and the issue price of such bonds is 20% or more, i.e., the issue price of deep discount bonds is 20% less than the face value of the bonds. 

Also read: Government bonds in India – Meaning, types and features

Features of deep discount bonds

• Deep discount bonds are high-risk bonds whose demand is significantly lower than others in the debt market.
• Deep discount bonds carry minimal to no periodic interest at all in some cases, as they offer heavy discounts at the time of issuance.
• Some deep discount bonds fall under the category of junk bonds as the creditworthiness of the issuer of such bonds is low. These bonds usually have concerns around repayment, making them highly risky.
• Similar to other bonds, the issuer must pay the face value to the owner of the bond during redemption, if it is held until maturity.

Bond prices and interest rates move inversely. If the interest rate in the market increases, the value of existing bonds offering lower interest rates falls. The low value naturally impacts the demand for such bonds. Issuers resort to offering bonds at discounts to overcome the lack of demand. When investors still do not find it attractive, issuers offer further discounts, leading to deep discount bonds. 

Deep discount bond calculation

The price of deep discount bonds can be calculated as below if the face value, discount rate and maturity period are known:

P = F/ (1+r)^n

P = Price, F = Face value, r= discount rate, n = Number of years till maturity.

The formula to calculate the yield-to-maturity (YTM) on discount bonds:

YTM = {C + [(F-P)/n)]} / {(F + P)/2}

C = Interest, F = Face value, P = Issue price, n = Number of years till maturity

Yield to maturity helps to ascertain the total returns earned from a bond that is held until its maturity.

Deep discount bonds example

Consider Company ABC Ltd offering bonds of face value ₹1,000 at an issue price of ₹750, with a maturity period of 3 years.

These bonds are issued at a discount of 25% and will be redeemed at ₹1,000 upon maturity.

Below are examples of some of the deep discount bonds issued in India:

• IDBI deep discount bonds: Industrial Development Bank of India (IDBI) was one of the initial issuers of discount bonds in 1992. The face value of the bond was ₹1,00,000, to be redeemed after a maturity period of 25 years. The bond was issued at ₹2,700.
• Sardar Sarovar Narmada Nigam Ltd deep discount bonds: SSNNL issued deep discount bonds in 1993 for a period of 20 years, with a face value of ₹1,11,000. The bond was offered at ₹3,600 in 1993.

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Deep discount bonds: Pros & cons

Pros of investing in deep discount bonds:

• Given the significant difference between the issue price and face value, deep discount bonds result in high profits.
• Deep discount bonds are usually low-priced compared to other bonds in the market, making discount bonds accessible to all kinds of investors.
• Deep discount bonds are suitable for long-term investors as they reap high profits at the time of maturity.
• Discount bonds are easily tradable in the secondary market, making these bonds highly liquid.

Cons of deep discount bonds:

• Issuers offering deep discount bonds are generally considered to be in distress. Anything available at a discount is usually seen as an item of low quality. Similarly, deep discount bonds are seen as instruments with low reputations.
• The possibility of defaults is high for deep discount bonds, making them high-risk investments.
• A zero-coupon bond is a variant of a deep discount bond that does not pay any interest. Such bonds defeat the purpose of fixed-income securities.

Bottomline

Deep discount bonds are debt instruments offered by the government and corporations to raise loans from the public. These bonds are offered at a price that is quite lower than their face value. Deep discount bonds are associated with high risks and returns. Hence, these bonds are a suitable avenue for those investors who are willing to take high risks for high returns in the long term.