What is a Discount Bond?
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. A bond is considered to trade at a discount when its coupon rate is lower than the prevailing interest rates. An example of a discount bond is the US savings bond.
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 the changes in the market interest rates. If interest rates go up, it results in a decline in the value of a bond; the opposite is also true. The fall in the value of the bond makes it attractive to investors since it is issued at a discount. The bond must, therefore, sell at a discount, hence the name discount bond. The discount takes into account the high risk of the bond, as well as the perceived instability 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 the investors pay a price that is 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 like stocks and their prices are bound to change with the changes in market conditions. However, the changes in bond values only affect the interest payable to bondholders, but the par value will still be repaid to the investors when the bond reaches maturity.
Why Bond Prices Fluctuate During Trading
When a new bond is issued in the open market, it a comes with a stated coupon that shows the amount of interest that bondholders will earn. For example, a bond with a par value of $1,000 and a coupon rate of 3% will pay an interest of $30 regardless of the changes in market conditions. If the prevailing interest rates drop to 2%, the bond value will rise, and the bond will be trading at a premium, e.g., $1,030. The Yield to Maturity (YTM) of the new bond price is 2. 91% ($30/$1,030). Similarly, if the interest rates rise to 4%, the value of the bond will drop, and the bond will trade at a discount, e.g., $970. The YTM of the new bond price will be 3.09% ($30/$970).
With the changing interest rates, bond prices must adjust so that their YTM equals or is almost equal to the YTM of the new bond issues. This is because the 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 (premium bond) so that the YTM becomes equal or almost equal to the interest rate. 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 dispose of their bond at a lower price than the par value for fear of losing all their investments.
2. Fluctuating interest rates
When interest rates rise above the coupon rate of the bond, investors pay a price that is lower than the bond’s par value. It allows them to earn a sufficient interest on their investment.
3. Credit rating review
A bond rating agency may lower the credit rating of an issuer and it may result in increased volumes of the bond on the market as bondholders dispose of their investments. The increased number of bonds on the market forces the holders to sell them at a discount to avoid the risk of default.
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. When the issuers continue to make timely interest payments, it may be an indication that the issuers will continue to honor their obligations until the bond matures. 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.
In contrast, 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 or because its equity shareholders are reluctant to invest more money into the company. 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 is high. It means that even in the bond market, a company faces a high risk of default and bondholders may lose their investments.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: