Deep Discount Bond

Deep discount bonds are issued significantly below their face value, resulting in higher yields to maturity (YTM). They serve as a means for issuers to raise funds and for investors to seek high-yield investments, capitalizing on the bond's appreciation towards maturity. These bonds hold significance by offering investors higher yields due to their discounted purchase price, which allows for capital appreciation.

For issuers, they provide a way to raise capital, though they come with the obligation to repay the bond's face value at maturity. They attract investors seeking higher returns and can aid companies in securing financing while reducing their periodic interest expenses due to lower or zero coupon payments. However, issuers must be prepared for the lump sum repayment at maturity.

Deep discount bonds, characterized by significant price reductions exceeding 20% of their face value, offer potentially high yields but raise concerns regarding issuer creditworthiness. These bonds often cater to entities with relatively lower credit ratings or facing temporary financial strain, requiring the allure of substantial discounts to attract investors.

They provide immediate capital appreciation potential upon maturity, compensating for the lower coupon payments compared to regular bonds. However, substantial discounts reflect the higher perceived risk of default associated with the issuer's creditworthiness.

These bonds often have longer maturities compared to standard bonds, further influencing their yield-to-maturity calculations. Deep discount bonds can be suitable for investors with a higher risk tolerance seeking potential capital appreciation, particularly over longer investment horizons. However, a meticulous evaluation of the issuer's creditworthiness and the associated risks is paramount before investing.

The formula P = F/ (1+r)^h calculates the price (P) of a deep discount bond, where:

• P is the price of the bond.
• F is its face value.
• r is the discount rate applied due to underlying risk factors.
• h is the bond's holding period.

This formula accounts for the effect of time and the discount rate on the bond's price, considering the reduced value due to the deep discount offered.

Let us look at the deep discount bond examples to understand the concept better -

Example #1

Let's consider a hypothetical scenario:

A tech conglomerate issues a deep discount bond within its subsidiaries, offering a 5-year term with a subscription price of $150 million and a face value of $200 million at maturity.

In this scenario, the intra-group financing arrangement utilizes the deep discount bond to address potential withholding tax concerns. The discount of $50 million (the variance between the subscription and face value) functions akin to interest but isn't classified as such. This setup helps manage tax implications while facilitating financing within the company's subsidiaries.

Example #2

India's REC plans to raise $603.2 million through a private placement of 10-year deep discount bonds by the end of March, leveraging a unique structure that is likely to attract strong investor demand. These bonds, issued at a significant discount of over 20% below face value, are expected to appeal to corporate treasuries and high-net-worth individuals due to the absence of regular interest payments and reinvestment risks, similar to zero-coupon notes. 

Discussions with the Central Board of Direct Taxes (CBDT) for potential tax benefits are underway, which could further boost investor interest, especially since state-run companies have ceased issuing tax-free bonds. Despite being issued at the end of the financial year, when many investors have completed their investment targets, bankers anticipate robust demand, pricing the bonds 6-8 basis points lower than other REC securities.

Advantages of deep discount bonds:

1. Higher Yield: Offers higher yields compared to other fixed-income securities due to their discounted purchase price.
2. Financing Flexibility: Allows issuers to raise funds at a lower upfront cost, attracting investors seeking high returns.
3. Market Appeal: Can attract investors looking for potentially lucrative, albeit riskier, investment opportunities.

Disadvantages of a deep discount bond

1. Issuer Risk: Typically issued by entities with lower credit ratings, posing a higher risk of default or delayed payments.
2. Reduced Liquidity: Lower demand in secondary markets due to their unique characteristics, potentially leading to reduced liquidity.
3. Interest Rate Sensitivity: Prone to interest rate fluctuations, impacting the bond's market value and making it more volatile compared to traditional bonds.

Understanding the Difference Between Deep Discount Bonds and Zero Coupon Bonds: While both deep discount bonds and zero coupon bonds are sold at significant discounts to their face value, they differ in their issuance, structure, and risk profiles.