What is a Discount Bond?

What is a Discount Bond?

A discount bond is a bond that is issued for less than its par—or face—value. Discount bonds may also be a bond currently trading for less than its face value in the secondary market. A bond is considered a deep-discount bond if it is sold at a significantly lower price than par value, usually at 20% or more.

A discount bond may be contrasted with a bond sold at a premium.

A discount bond is a bond that is issued, or trades in the market for less than its par or face value.

A distressed bond trading at a significant discount to par can effectively raise its yield to attractive levels.

How a Discount Bond Works

When an investor purchases a bond, he/she expects to be paid interest by the bond issuer. However, the value of the bond is likely to increase or decrease with changes in the market interest rates. If interest rates go up, it results in a decline in the value of the bond. The bond must, therefore, sell at a discount. Hence the name, discount bond. The discount takes into account the risk of the bond and the creditworthiness of the bond issuer.

A discount bond is offered at a lower price than the prevailing market rate. Buying the bond at a discount means that investors pay a price lower than the face value of the bond. However, it does not necessarily mean it offers better returns than other bonds.

Let take an example of a bond with a $1,000 face value. If the bond is offered at $970, it is considered to be offered at a discount. If the bond is offered at $1,030, it is considered to be offered at a premium. Bonds trade in the secondary market and their prices change with changes in market conditions. However, the par value will still be repaid to investors when the bond reaches maturity.

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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.

Default Risk with Discount Bonds

If you buy a discount bond, the chances of seeing the bond appreciate are reasonably high, as long as the lender doesn’t default. If you hold out until the bond matured, you’ll be paid the face value of the bond, even though what you originally paid was less than face value. Maturity rates vary between short-term and long-term bonds. Short-term bonds mature in less than one year while long-term bonds can mature in 10 to 15 years, or even longer.

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However, the chances of default for longer-term bonds might be higher, as a discount bond can indicate that the bond issuer might be in financial distress. Discount bonds can also indicate the expectation of issuer default, falling dividends, or a reluctance to buy on the part of the investors. As a result, investors are compensated somewhat for their risk by being able to buy the bond at a discounted price.

Example of a Discount Bond

As of March 28, 2019, Bed Bath & Beyond Inc. (BBBY) has a bond that’s currently a discount bond. Below are the details of the bond including its the bond issue number, coupon rate at the time of the offering, and other information.

  • Issue: BBBY4144685
  • Description: BED BATH & BEYOND INC
  • Coupon Rate: 4.915
  • Maturity Date: 08/01/2034
  • Yield at Offering: 4.92%
  • Price at Offering: $100.00
  • Coupon Type: Fixed

The current price for the bond, as of a settlement date of March 29, 2019, was $79.943 versus the $100 price at the offering. For reference, the 10-year Treasury yield trades at 2.45% making the yield on the BBBY bond much more attractive than current yields. However, BBBY has had financial difficulty over the last few years, making the bond risky as we can see that it trades at a discount price despite the coupon rate being higher than the current yield on a 10-year Treasury note.

The yield has at times, traded higher than the coupon rate with some days as high as 7%, which further indicates that the bond is deeply discounted since the yield is much higher than the coupon rate while its price much lower than its face value.