A discount bond is a bond that is issued at a lower price than its par value or a bond that is trading in the secondary market at a price that is below the par value. It is similar to a zero-coupon bond, only that the latter does not pay interest until maturity. A bond is considered to trade at a discount when its coupon rate is lower than the prevailing interest rates.
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.
Why Bond Prices Fluctuate During Trading
When a new bond is issued, it comes with a stated coupon that shows the amount of interest bondholders will earn. For example, a bond with a par value of $1,000 and a coupon rate of 3% will pay annual interest of $30. If the prevailing interest rates drop to 2%, the bond value will rise, and the bond will trade at a premium. If interest rates rise to 4%, the value of the bond will drop, and the bond will trade at a discount.
With changing interest rates, bond prices must adjust so that their YTM equals or is almost equal to the YTM of new bond issues. This is because bond prices and YTMs move in opposite directions. If interest rates are higher than the bond’s coupon rate, bond prices must decrease below the par value (discount bond) so that the YTM moves closer to the interest rates. Similarly, if interest rates drop below the coupon rate, bond prices rise above the par value. During periods when interest rates are continually falling, bonds will trade at a premium so that the YTM moves closer to the falling interest rates. Similarly, rising interest rates will result in more bonds trading at a discount of par value.
Why a Bond Sells at a Discount
A bond may be issued at a discount for the following reasons:
1. Bond issuer’s risk of default
When bondholders perceive the issuer as being at a higher risk of defaulting on their obligations, they may only be willing to purchase the bonds at a discount.
2. Fluctuating interest rates
When interest rates rise above the coupon rate of the bond, the bond will trade at a discount. This allows them to earn a sufficient return on their investment.
3. Credit rating review
A bond rating agency may lower the credit rating of an issuer. The lower rating means increased risk, so the bond will trade at a discount to compensate investors for the additional risk.
Pros and Cons of Investing in Discount Bonds
Discount bonds come with a high probability of appreciating in value as long as the bond issuer does not default. If the investors hold their bonds until maturity, they will be paid an amount equal to the par value of the bond, even though they initially paid an amount that is less than the bond’s par value.
Discount bonds may come with a higher risk of default depending on the financial status of the issuer. A company may opt to issue bonds after exhausting all other means of raising capital. A bond rating agency may also lower the rating of the issuer if it is convinced that the probability of the company defaulting on its current obligations has increased.
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