Deep-discount bond – explained

A bond is a loan taken by an entity, typically corporate or government. It is a fixed income instrument issued with a promise of interest payments at predetermined intervals, and the return of the principal amount to the lender on the date of maturity. A deep-discount bond is a subcategory of bonds sold for much lower than its face, or par, value. 

A deep-discount bond means a promise by the bond’s issuer to pay the bondholder on the maturity date an amount greater than the amount originally received.

To further define a deep-discount bond, note that any bond sold at a discount of greater than 20% of its market value is classified as a deep-discount bond. The common features of a deep-discount bond are:

• Coupon payments – A deep-discount bond typically pays low or no coupon payments (zero-coupon bonds) to the bondholder during its entire hold period. The bondholder is compensated with the par value of the issued bond, at the time of maturity.

• Sensitive to interest rate fluctuations – Bond prices tend to have a negative or inverse relationship with interest rates. This is because when the cost of borrowing money increases, bond prices decrease to make it more attractive to investors. Deep-discount bonds, which offer low or no periodic payments until maturity, remain very sensitive to a change in interest rates. Compared to regular bonds, which provide periodic interest payments, the prices of deep-discount bonds fluctuate more.

• Maturity period – A deep-discount bond is typically issued for a longer time frame, with a maturity period of five years or longer and call provisions. An embedded call provision in the contract allows the bond issuing entity to repurchase the bond during its holding period and retire the debt security before its maturity.

• High risk – The holder of a deep-discount bond will typically not receive any periodic interest payments. Pricing for these bonds is quite low. There are inherent concerns regarding the credibility of such issuers. However, zero-coupon bonds are an exception to this feature.

Zero-coupon bonds

A zero-coupon bond is a debt security that pays no interest to the holder. The investor’s return is the difference between the zero-coupon bond’s par value and its purchase price.

While a zero-coupon bond is an example of a deep-discount bond, there are differences between zero-coupon bonds and deep-discount bonds.

The credibility of a deep-discount bond is always under scrutiny because it’s offered at a price lower than its par value. Investors could find themselves holding a deep-discount bond when the company’s credit rating gets downgraded. A zero-coupon bond is always packaged and sold as a financial debt. It’s issued at a discount but will reach its par value during its holding period. US Treasury bills are a prime example of a zero-coupon bond, wherein the credibility of the issuer is of the highest order.

While a deep-discount bond may pay some interest through coupon payments to the bondholder, a zero-coupon bond makes no such coupon payments throughout its holding period. The investor only profits at maturity, when they redeem the bond for its full-face value and get a price higher than they paid for it.

Example and calculation of deep-discount bond

Say a zero-coupon or deep-discount bond has a face value of $1,000 and a discount rate of 8%, maturing in a year’s time. We can calculate the price of a deep-discount bond using the following formula:

Price of bond = 1,000/ (1+4%) ^2

Price = $924.55

In conclusion, if one pays $924.55 for this deep-discount bond at this time and gets $1,000 after holding it for a year, their annualised implied yield would be equal to 8%.