What is a discount bond?
A discount bond is a bond issued for an amount less than its nominal or nominal value. Discount bonds can also be bonds that are currently trading at a price below their face value on the secondary market. A bond is considered a high discount bond if it is sold at a price significantly lower than the nominal value, generally at 20% or more.
Bond yield: current yield and YTM
Key points to remember
- A discount bond is a bond issued for an amount less than its nominal or nominal value.
- Discount bonds can also currently be traded at a price below their nominal value on the secondary market.
- A distressed bond traded at a significant discount compared to the peer can effectively increase its yield to attractive levels.
- Discount bonds may indicate a belief that the underlying company may default on its debt obligations.
Understand delivery obligations
Many bonds are issued with a nominal value of $ 1,000, which means that the investor will be paid $ 1,000 at maturity. However, bonds are often sold before maturity and purchased by other investors on the secondary market. Bonds that trade below face value would be considered discount bonds. For example, a bond with a face value of $ 1,000 that currently sells for $ 95 would be a discounted bond.
Since bonds are a type of debt instrument, bondholders or investors receive interest from the bond issuer. This interest is called a coupon which is generally paid semi-annually but, depending on the obligation, can be paid monthly, quarterly or even annually. Discount bonds can be bought and sold by institutional and individual investors. However, institutional investors must comply with specific regulations for the sale and purchase of discount bonds. A common example of a discount bond is an American savings bond.
Interest rates and coupons
Bond yields and bond prices have an opposite or opposite relationship. As interest rates rise, the price of a bond will decrease and vice versa. A bond that offers bondholders an interest or coupon rate below the current market interest rate would likely be sold at a price below its face value. This drop in price is due to the possibility for investors to buy a similar bond or other securities offering a better return.
For example, say, interest rates go up after an investor has bought a bond. The higher interest rate in the economy decreases the value of the newly purchased bond due to the payment of a lower rate than the market. This means that if our investor wants to sell the bond on the secondary market, he will have to offer it at a lower price. If prevailing market interest rates rise enough to push the price or value of a bond below its face value, this is called a discount bond.
However, the “haircut” in a discount bond does not necessarily mean that the investors get a better return than that offered by the market. Instead, investors get a lower price to compensate for the lower yield on the bond compared to interest rates in the current market. For example, if a corporate bond trades at $ 980, it is considered a discount bond since its value is less than the face value of $ 1,000. When a bond becomes discounted or drops in price, it means that its coupon rate is lower than current yields.
Conversely, if current interest rates fall below the coupon rate offered on an existing bond, the bond will trade at a premium or at a price above face value.
Use of yield to maturity
Investors can convert old bond prices to their current market value using a calculation called yield to maturity (YTM). The yield to maturity takes into account the current market price of the bond, the nominal value, the coupon interest rate and the time to maturity to calculate the yield of a bond. Calculating the YTM is relatively complex, but many online financial calculators can determine the YTM of a bond.
Risk of default with discount bonds
If you buy a bond at a discount, the chances of the bond appreciating are reasonably high, as long as the lender does not default. If you hold on until the bond matures, you will be paid the face value of the bond, even if what you originally paid was less than the face value. The maturity rates vary between short-term bonds and long-term bonds. Short-term bonds mature in less than a year, while long-term bonds can mature in 10 to 15 years or more.
However, the chances of default on longer-term bonds may be higher, as a discount bond may indicate that the bond issuer may be in financial difficulty. Discount bonds can also indicate an expectation of default by the issuer, a decline in dividends or a reluctance to buy from investors. As a result, investors are somewhat compensated for their risk by being able to buy the bond at a reduced price.
Distressed and zero coupon bonds
A distressed bond is one that has a high probability of default and can be traded at a significant discount compared to the peer, which would effectively increase its yield to desirable levels. However, distressed bonds are generally not expected to pay full or timely interest. As a result, investors who buy these securities are playing a speculative game.
A zero coupon bond is a great example of high discount bonds. Depending on the term to maturity, zero coupon bonds can be issued with substantial discounts at par, sometimes 20% or more. Because a bond will always pay its face value at maturity – assuming no credit events occur – zero coupon bonds will increase steadily as the maturity date approaches. These bonds do not make periodic interest payments and will only make one payment of the nominal value to the bearer at maturity.
Advantages and disadvantages of discount bonds
Just like buying any other product at a reduced price, there is a risk for the investor, but there are also rewards. Since the investor buys the investment at a reduced price, it offers more opportunities for greater capital gains. The investor must weigh this advantage against the disadvantage of paying taxes on these capital gains.
Bond holders can expect to receive regular returns unless the product is a zero coupon bond. In addition, these products have short and long term maturities to meet the needs of the investor’s portfolio. Taking into account the creditworthiness of the issuer is important, especially for longer-term bonds, because of the risk of default. The existence of the discount in the offer indicates that the underlying company is afraid of being able to pay dividends and repay the capital at maturity.
The potential for capital gains is high as bonds sell for less than face value, some being offered at a large discount of 20% or more.
Investors receive regular interest, usually semi-annually, unless the offer is a zero coupon bond.
Discount bonds are available with short term and long term maturities.
Discount bonds can indicate anticipation of an issuer default, a decline in dividends or an unwillingness of investors to buy debt.
Longer-term discount bonds have a higher risk of default.
Deeper updated obligations indicate that a company is in financial difficulty and risks defaulting on its obligation.
Real example of a discount bond
As of March 28, 2019, Bed Bath & Beyond Inc. (BBBY) has an obligation which is currently a discount obligation. You will find below the details of the bond, including its issue number, the coupon rate at the time of the offer and other information.
- Problem: BBBY4144685
- Description: BED BED AND BEYOND INC
- Coupon Rate: 4,915
- Maturity date: 08/01/2034
- Bid yield: 4.92%
- Offer price: $ 100.00
- Coupon Type: Fixed
The current price of the bond, on the settlement date of March 29, 2019, was $ 79,943 compared to the price of $ 100 at the time of the offer. For reference, the 10-year Treasury yield trades at 2.45%, which makes the yield on the BBBY bond much more attractive than current yields. However, BBBY has had financial difficulties in recent years, which has made borrowing risky, as we can see that it is trading at a discount price despite the coupon rate being higher than the current yield of a 10-year Treasury bill.
The yield was sometimes higher than the coupon rate with certain days up to 7%, which also indicates that the bond is deeply discounted because the yield is much higher than the coupon rate while its price is much lower at its nominal value.