Skip to main content
diversification.com
← Back to D Definitions

Deep discount bond

What Is Deep-discount bond?

A deep-discount bond is a type of fixed-income security that is issued or trades at a price significantly below its face value, typically 20% or more.49 Unlike conventional bonds that pay regular interest payments (coupons) throughout their life, deep-discount bonds often offer minimal or no periodic coupon rate.46, 47, 48 The primary return for investors in a deep-discount bond comes from the capital appreciation realized when the bond reaches its maturity and is redeemed at its full face value.43, 44, 45

This substantial discount usually reflects either the issuer's lower creditworthiness, suggesting a higher perceived default risk, or it can occur when the bond's stated coupon rate is considerably lower than prevailing interest rates in the market.42 Some deep-discount bonds are also a form of zero-coupon bond, where the entire interest is embedded in the discount.40, 41

History and Origin

While the concept of bonds trading at a discount due to market conditions or credit concerns is as old as the bond market itself, the term "deep-discount bond" gained particular prominence alongside the rise of the high-yield, or "junk," bond market. The modern era of junk bonds began to take shape in the 1970s and experienced a significant boom in the 1980s. During this period, companies, including those with lower credit ratings, increasingly utilized these securities to finance their growth, mergers, and leveraged buyouts.39

Pioneering figures like Michael Milken helped build a large market for these higher-risk, higher-return bonds, which often traded at substantial discounts to their face value to compensate investors for the added risk.38 Early instances of deep-discount bonds being explicitly issued include those from the Industrial Development Bank of India (IDBI) in 1992 and ICICI Bank in 1996, which were offered at very low prices compared to their high face values.35, 36, 37 The market for new-issue junk bonds, closely related to deep-discount bonds, notably reopened in 1977, facilitating financing for many below-investment-grade companies.34

Key Takeaways

  • A deep-discount bond is sold at a price significantly below its face value, with the investor's return primarily deriving from the appreciation to par at maturity.32, 33
  • These bonds often pay minimal or no periodic interest payments (coupons).30, 31
  • The deep discount can indicate higher perceived risk due to the issuer's credit profile or a lower coupon rate compared to current market interest rates.
  • They can be attractive to investors seeking capital gains and those who do not require regular income streams from their investments.28, 29
  • Deep-discount bonds are generally more sensitive to changes in interest rates than bonds paying regular coupons.27

Formula and Calculation

The pricing of a deep-discount bond, especially one that behaves like a zero-coupon bond, fundamentally relies on the concept of the present value of its future face value. The formula for calculating the price (P) of such a bond is:

P=F(1+r)nP = \frac{F}{(1 + r)^n}

Where:

  • (P) = Current market price of the bond
  • (F) = Face value (or par value) of the bond
  • (r) = Yield to maturity (YTM), or the discount rate, expressed as a decimal
  • (n) = Number of years to maturity

This formula essentially discounts the bond's future face value back to the present using the required rate of return (YTM). The larger the discount, the higher the implicit yield or return an investor receives if they hold the bond until maturity.

Interpreting the Deep-discount bond

Interpreting a deep-discount bond involves understanding the trade-off between its low purchase price and the inherent risks. The significant discount primarily reflects the bond's yield to maturity (YTM), which is the total return an investor expects to receive if they hold the bond until it matures. A higher YTM indicates a larger discount.25, 26

For investors, a deep discount can signal one of two main scenarios: either the issuer has a lower credit rating, meaning there's a higher risk of default, or the bond was issued with a very low coupon rate in a higher interest rate environment. Therefore, investors must thoroughly assess the issuer's financial health and the reasons for the deep discount. A deep-discount bond from a strong issuer (like certain zero-coupon Treasury bonds) might be a deliberate investment choice for capital appreciation, while one from a struggling company indicates a speculative bet on recovery. Understanding the bond's duration is also critical, as deep-discount bonds, especially zero-coupon ones, tend to have longer durations and are thus more sensitive to interest rate fluctuations.

Hypothetical Example

Imagine Investor Sarah is looking for a long-term investment opportunity. She finds a deep-discount bond offered by "InnovateTech Inc." with a face value of $1,000, a maturity period of 10 years, and no annual coupon payments. The bond is currently trading at $400.

Sarah applies the deep-discount bond concept:

  • Face Value (F): $1,000
  • Current Price (P): $400
  • Years to Maturity (n): 10 years

To find the implied yield to maturity (r), she would rearrange the formula:

r=(FP)1n−1r = \left(\frac{F}{P}\right)^{\frac{1}{n}} - 1

r=($1000$400)110−1r = \left(\frac{\$1000}{\$400}\right)^{\frac{1}{10}} - 1

r=(2.5)0.1−1r = (2.5)^{0.1} - 1

r≈1.096−1r \approx 1.096 - 1

r≈0.096 or 9.6%r \approx 0.096 \text{ or } 9.6\%

Sarah calculates that if she holds this deep-discount bond until maturity, her annualized return would be approximately 9.6%. This example highlights that despite a low initial investment, the deep discount offers a substantial return potential over the bond's life, assuming InnovateTech Inc. repays the bond in full. This kind of investment aligns with strategies focused on capital appreciation rather than current income.

Practical Applications

Deep-discount bonds serve various purposes in the financial markets for both issuers and investors.

  • Corporate Financing: Companies, especially those in growth phases or with variable cash flows, may issue deep-discount bonds to raise capital without the immediate burden of regular interest payments.23, 24 This can be particularly appealing for financing long-term projects where initial cash generation is limited.
  • Speculative Investing: Investors with a higher risk tolerance may seek deep-discount bonds in the secondary market, especially those from financially distressed companies. The deep discount in such cases reflects the market's skepticism about repayment, but if the company recovers, the potential for significant capital gains can be substantial. These often fall into the category of high-yield or junk bonds, which have been a significant part of the corporate bond market, experiencing periods of both boom and crisis. For instance, the U.S. high-yield bond market grew from $10 billion in 1979 to $189 billion by 1989.22
  • Target-Date Investing: Zero-coupon deep-discount bonds can be suitable for investors saving for a specific future financial goal, such as a child's education or retirement. By purchasing a bond that matures precisely when funds are needed, investors can lock in a return and eliminate reinvestment risk.21
  • Tax Considerations: The Internal Revenue Service (IRS) classifies the accrued discount on bonds, including deep-discount bonds, as Original Issue Discount (OID). This OID must generally be reported as income by the bondholder annually, even though no cash interest is received until maturity.19, 20

Limitations and Criticisms

Despite their potential for high returns, deep-discount bonds come with notable limitations and criticisms.

  • Higher Default Risk: One of the most significant drawbacks is the elevated default risk. Bonds trading at a deep discount often do so because the market perceives the issuer to be financially unstable or to have a lower credit rating. If the issuer defaults, investors may lose their entire principal investment.16, 17, 18 Vanguard highlights that bonds with lower credit ratings generally carry greater credit risk, increasing the risk of defaults.15
  • Interest Rate Sensitivity: Deep-discount bonds, particularly those with longer maturities and no coupon payments, are highly sensitive to changes in interest rates. If interest rates rise, the market price of existing deep-discount bonds will typically fall more sharply than coupon-paying bonds, leading to potential capital losses if sold before maturity.13, 14
  • No Regular Income: For investors seeking a steady stream of income from their portfolio, deep-discount bonds are unsuitable as they provide little to no periodic income.12 The return is concentrated at maturity.
  • Tax Implications: As mentioned, the "imputed interest" or Original Issue Discount (OID) on deep-discount bonds is generally taxable annually, even though the investor does not receive cash payments. This can create a "phantom income" tax liability, meaning investors owe taxes on income they haven't yet received.11 This requires investors to have external funds available to cover the tax obligation.

Deep-discount bond vs. Zero-coupon bond

While often used interchangeably or viewed as highly similar, there's a subtle distinction between a deep-discount bond and a zero-coupon bond.

A deep-discount bond is defined by its trading price relative to its face value—specifically, a bond selling at a significant discount (typically 20% or more) to its par value. This discount can arise for various reasons, including the bond being a zero-coupon instrument, having a very low coupon rate compared to prevailing market rates, or being issued by an entity with a questionable credit profile.

10A zero-coupon bond, by definition, is a bond that does not pay periodic interest payments (coupons). Instead, it is always issued at a discount to its face value and pays the full face value at maturity. W8, 9hile all zero-coupon bonds are discount bonds, not all deep-discount bonds are zero-coupon bonds. A bond with a very low, but non-zero, coupon rate that trades at a substantial discount due to market conditions or credit concerns would be considered a deep-discount bond but not a zero-coupon bond. However, in practice, many deep-discount bonds are indeed zero-coupon bonds because the absence of coupon payments inherently leads to a lower issue price. T6, 7he confusion often arises because zero-coupon bonds are the most common type of bond issued at a deep discount.

FAQs

What causes a bond to become a deep-discount bond?

A bond becomes a deep-discount bond primarily for two reasons: either it is issued with a very low or zero coupon rate, meaning the return is built into the difference between the purchase price and the face value at maturity, or the issuer's credit quality has deteriorated, increasing the perceived default risk and causing the bond's market price to fall significantly.

Are deep-discount bonds safe investments?

Deep-discount bonds are generally considered riskier than traditional, high-quality bonds that pay regular interest. The level of risk largely depends on the issuer's creditworthiness. Bonds from financially stable governments or highly-rated corporations might be relatively safe, while those from struggling companies (often referred to as junk bonds) carry substantial risk.

4, 5### How do interest rate changes affect deep-discount bonds?
Deep-discount bonds are highly sensitive to changes in interest rates. Because they often don't pay regular coupons, their price fluctuations are more pronounced. When interest rates rise, the value of existing deep-discount bonds typically falls significantly, and conversely, their value appreciates more when interest rates decline. T3his heightened sensitivity is due to their longer effective duration.

Do I have to pay taxes on deep-discount bonds before maturity?

Yes, for many deep-discount bonds, particularly those classified as Original Issue Discount (OID) instruments by the IRS, you are generally required to report a portion of the discount as taxable income each year, even though you don't receive cash until the bond matures. T1, 2his is known as "phantom income" and applies even if you haven't sold the bond.