Discount Bond

What Is a Discount Bond?

A discount bond is a bond that is issued for not exactly its par — or face — value. Discount bonds may likewise be a bond currently trading for not exactly its face value in the secondary market. A bond is considered a deep-discount bond in the event that it is sold at a fundamentally lower price than par value, typically at 20% or more.

A discount bond might be stood out from a bond sold at a premium.

Understanding Discount Bonds

Many bonds are issued with a $1,000 face value meaning the investor will be paid $1,000 at maturity. Be that as it may, bonds are frequently sold before maturity and bought by different investors in the secondary market. Bonds that trade at a value of not as much as face value would be viewed as a discount bond. For instance, a bond with a $1,000 face value that is currently selling for $95 would be a discounted bond.

Since bonds are a type of debt security, bondholders or investors receive interest from the bond's issuer. This interest is called a coupon that is normally paid semiannually yet, contingent upon the bond might be paid month to month, quarterly, or even every year. Discount bonds can be bought and sold by both institutional and individual investors. Notwithstanding, institutional investors must comply to specific regulations for the selling and purchasing of discount bonds. A common illustration of a discount bond is a U.S. savings bond.

Interest Rates and Discount Bonds

Bond yields and bond prices have an inverse, or inverse, relationship. As interest rates increase, the price of a bond will diminish, and vice versa. A bond that offers bondholders a lower interest or coupon rate than the current market interest rate would probably be sold at a lower price than its face value. This lower price is due to the opportunity investors need to buy a comparable bond or different securities that give a better return.

For instance, suppose, interest rates rise after an investor purchases a bond. The higher interest rate in the economy diminishes the value of the recently bought bond due to paying a lower rate versus the market. That means to sell the bond on the secondary market, they should offer it for a lower price. Should the overall market interest rates rise to the point of pushing the price or value of a bond below its face value it's alluded to as a discount bond.

Notwithstanding, the "discount" in a discount bond doesn't be guaranteed to mean that investors get a better yield than the market is offering. All things considered, investors are getting a lower price to offset the bond's lower yield relative to interest rates in the current market. For instance, on the off chance that a corporate bond is trading at $980, it is viewed as a discount bond since its value is below the $1,000 par value. As a bond becomes discounted or diminishes in price, it means its coupon rate is lower than current yields.

On the other hand, on the off chance that current interest rates fall below the coupon rate offered on an existing bond, the bond will trade at a premium or a price higher than face value.

Utilizing Yield to Maturity

Investors can change more seasoned bond prices over completely to their value in the current market by utilizing a calculation called yield to maturity (YTM). Yield to maturity considers the bond's current market price, par value, coupon interest rate, and time to maturity to work out a bond's return. The YTM calculation is relatively perplexing, yet numerous online financial calculators can determine the YTM of a bond.

Default Risk with Discount Bonds

In the event that you buy a discount bond, the chances of seeing the bond appreciate are sensibly high, the same length as the lender doesn't default. Assuming you hold out until the bond matured, you'll be paid the face value of the bond, even however what you initially paid was not as much as face value. Maturity rates fluctuate between short-term and long-term bonds. Short-term bonds mature in under one year while long-term bonds can mature in 10 to 15 years, or even longer.

Notwithstanding, the chances of default for longer-term bonds may be higher, as a discount bond can demonstrate that the bond issuer may be in financial distress. Discount bonds can likewise demonstrate the expectation of issuer default, falling dividends, or a hesitance to buy with respect to the investors. Thus, investors are compensated to some degree for their risk by having the option to buy the bond at a discounted price.

Distressed and Zero-Coupon Bonds

A distressed bond is a bond that has a high probability of default and can trade at a huge discount to par, which would really raise its yield to desirable levels. Be that as it may, distressed bonds are not generally expected to pay full or opportune interest payments. Thus, investors who buy these securities are making a speculative play.

A zero-coupon bond is a great illustration of deep discount bonds. Contingent upon the time span until maturity, zero-coupon bonds can be issued at significant discounts to par, sometimes 20% or more. Since a bond will constantly pay its full, face value, at maturity — expecting no credit events happen — zero-coupon bonds will consistently rise in price as the maturity date draws near. These bonds don't make periodic interest payments and will just make one payment of the face value to the holder at maturity.

The Pros and Cons of Discount Bonds

Similarly likewise with buying whatever other discounted products there is risk implied for the investor, however there are additionally a few rewards. Since the investor buys the investment at a discounted price it gives greater opportunity to greater capital gains. The investor must gauge this advantage against the disadvantage of paying taxes on those capital gains.

Bondholders can hope to receive standard returns except if the product is a zero-coupon bond. Additionally, these products come in long and short-term maturities to fit the investor's portfolio needs. Consideration of the creditworthiness of the issuer is important, particularly with longer-term bonds, due to the chance of default. The presence of the discount in the offering demonstrates some concern of the underlying company is having the option to pay dividends and return the principal on maturity.

As of March 28, 2019, Bed Bath and Beyond Inc. (BBBY) has a bond that is currently a discount bond. Below are the subtleties of the bond including its the bond issue number, coupon rate at the hour of the offering, and other data.

• Issue: BBBY4144685
• Description: BED BATH and 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, starting around 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 considerably more appealing than current yields. Notwithstanding, BBBY has had financial difficulty throughout recent years, making the bond risky as we can see that it trades at a discount price regardless of the coupon rate being higher than the current yield on a 10-year Treasury note.

The yield has on occasion, traded higher than the coupon rate for certain days as high as 7%, which further shows that the bond is deeply discounted since the yield is a lot higher than the coupon rate while its price a lot of lower than its face value.

Highlights

• A discount bond is a bond that is issued, or trades in the market for not exactly its par or face value.
• A distressed bond trading at a huge discount to par can really raise its yield to appealing levels.
• Discount bonds might show the conviction that the underlying company might default on their debt obligations.