Discount bond definition
/What is a Discount Bond?
A discount bond is a type of bond that is issued or trades in the market at a price lower than its face (or par) value. This discount occurs for several reasons, such as rising market interest rates, perceived credit risk of the issuer, or simply because the bond's coupon rate is lower than current prevailing rates. For instance, if a bond has a face value of $1,000 but is sold for $950, it is considered a discount bond. Investors purchase discount bonds with the expectation of earning a profit when the bond matures, as they will receive the full face value, thus realizing a gain. The difference between the purchase price and the face value represents the investor's interest income, which is recognized gradually over the bond’s life. Discount bonds are particularly appealing to investors seeking potential capital appreciation, especially when interest rates are anticipated to decline, which would cause bond prices to rise. However, investing in discount bonds also involves risks, such as the issuer's potential inability to repay the full face value at maturity.
Why a Bond Sells at a Discount
There are several reasons why a bond sells at a discount to its face value. First, the current market interest rate is higher than the interest rate being paid by the issuer, so investors pay less for the bond in order to derive a higher effective interest rate on their investment. Second, investors perceive the issuer as being at risk of not redeeming the bonds it has issued, and so are willing to sell their bonds at a reduced price in order to avoid the risk of default. And third, when a credit rating agency reduces the credit rating of an issuer, this can trigger a high volume of selling by investors on the secondary market, which lowers the price of a bond; this is a similar issue to the preceding default risk comment.
A bond may sell at a deep discount to its face value if the interest rate paid by the issuer is much lower than the market interest rate. The discount is especially deep when the issuer sells zero-coupon bonds, where investors must rely upon the size of the discount in order to earn any effective interest rate (since the issuer is paying no interest). In these cases, an investor has an opportunity to realize substantial capital gains when the bonds are eventually redeemed. Any discount bond will gradually increase in price as its redemption date approaches, since the issuer always repays the face value of the bond; that is, no bond is repaid at a discount from its face value.
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The Use of Discount Bonds in Acquisitions
An investor may buy bonds that are selling on the secondary market at a discount, not to obtain a high rate of interest, but rather to exercise control over the issuer. This circumstance can arise when the issuer is experiencing financial difficulties, so its bonds are selling at such a low price that an investor can buy up a large amount of the distribution for a minimal investment. This variation is particularly likely when bonds are convertible into company common stock, so that investors can buy bonds with the intent of acquiring shares in the issuer at a low price.
Advantages of Discount Bonds
There is a particular advantage associated with investing in discount bonds. When doing so, you will not only earn income from the normal stream of coupon payments, but will also earn a capital gain when the bond eventually matures. This means that you will pay ordinary income on the coupon income, but a reduced capital gain tax rate on the amount of the capital gain. This can represent a substantial tax savings if you purchased the bonds at a deep discount.