Deep Discount Bonds – Advantages and Calculation Explained
There are different types of bonds available for lending in the markets, and deep discount bonds are one of them. As the name suggests, deep discount bonds come at heavy discounts on their face value; however, they also offer low-interest rates.
In this piece, we have simplified the concept of deep discount bonds, their examples, advantages and how they are calculated.
What is a Deep Discount Bond?
Deep discount bonds are bonds that are sold at a price more than 20% lower than their face value. It has a higher yield than other fixed-income securities of similar nature. The lower rate of interest and higher yields of these bonds is due to the fact that the issuers are not that credible, and their ability to pay principal and interest on time is quite low.
However, zero coupon bonds are an exception as they will trade at deep discounts even though issuers have high credit ratings. This is because of the nil interest component and rising yield as the bond reaches closer to maturity.
How Do Deep Discount Bonds Work?
Deep discount bonds trade at a value that is quite lower than the par value of other fixed-income securities. Issuers offer discounts of at least 20% on the face value of these bonds because of two reasons. Firstly, deep discount bonds come at lower coupon rates than other bonds. Secondly, the credibility of issuers is not that great.
There is an element of risk in these bonds, and discounts are offered to make them more lucrative. The higher the risk on these bonds, the higher will be the discounts offered on them. A zero-coupon bond is similar to a deep discount bond as it does not come with any interest. Discounts offered on zero-coupon bonds serve as interest for prospective investors.
Calculation of Deep Discount Bonds
You can compute the price of these bonds using the following formula:
P = F/ (1+r)^h;
Here, P implies price of deep discount bonds;
F is its face value;
r is the discount rate that issuers offer due to underlying risk factors; and
h is the bond’s holding period.
Example of Deep Discount Bond
Let’s understand the working of discount bonds with the help of an example:
Suppose you are holding a discount bond whose face value is Rs. 20,000 and which comes at a coupon rate of 10% per annum. The period left for the maturity of these bonds is 2 years. Using the formula mentioned above, we can calculate the price of the respective bond:
Price = 10000 / (1+5%)^4
= Rs.8,200.
We must note that to maintain standards of coupon-bearing bonds, we have divided the rate of interest by 2 and multiplied the holding period variable by 2 as well. Therefore, if an investor buys this bond for Rs.8,200 and receives full face value at the end of the holding period of 2 years, his/her effective coupon or interest rate will amount to 10%.
What are NABARD Bonds?
National Bank for Agriculture and Rural Development (NABARD) has launched deep discount bonds for prospective investors. As these bonds are issued by an established government department, the credit risk associated with them is quite low.
One of the major advantages of investing in these bonds is that all interest earned on them does not attract any tax under the Income Tax Act 1961. As there is no taxation, there is no scope or chance of TDS deductions on them. The face value of NABARD-denominated bonds is Rs. 1,000, and the minimum investment amount is Rs. 5,000.
The coupon rates on the bonds vary as per their tenure. These bonds are one of the best investment options due to high liquidity, and these are easily tradable on stock markets. Moreover, you can keep these bonds in physical offline form and do not have to open a Demat account for it and incur additional costs.
What are the Advantages of Deep Discount Bonds?
Here are some advantages of deep discount bonds:
- There are chances of significant capital appreciation on the purchase of these bonds. If you hold these bonds till maturity, you are liable to receive the face value, although you purchased them at low prices. Therefore, there is scope for huge capital gains.
- These are fairly simple modes of investment, and you do not require any assistance from underwriters or brokers. This saves brokerage and commission costs.
- It is ideal for long-term financial goals as the maturity period of these bonds is more than 5 years.
- The minimum investment on these bonds is quite low; thereby, it is open to all types of investors.
- Moreover, the liquidity of these bonds is quite high, and you can easily trade them in secondary markets.
What are the Disadvantages of Deep Discount Bonds?
Some cons of investing in deep discount bonds are as follows:
- The credit risk profile of issuers is always a matter of concern, and there is quite a high possibility of default.
- Some bonds, like zero coupon bonds, are not fixed-income securities. You will not have the luxury of getting recurring income.
- Capital gains arising from these are subject to taxation. It may negate all or some of the gains that one has made.
Deep Discounts vs Zero Coupon Bonds
Some differences between deep discount bonds and zero-coupon bonds are as follows:
| Parameter | Deep Discount | Zero-Coupon |
| Interest | These bonds come with an interest or coupon, which borrowers must pay periodically. | As the name suggests, these do not come with any interest or coupon. |
| Taxation | The difference between face value and subscription price is subject to taxation, and TDS is deducted. | In zero-coupon bonds, only the capital gains are subject to taxation. |
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Final Word
Deep discount bonds are an immensely popular investment alternative due to the prospects of significant capital appreciation. However, as the risk in these bonds is quite high, it is imperative for investors to conduct a thorough market analysis before putting their money in them.
FAQs
Ans. The difference between the subscription price and redemption price of a deep discount bond will be subject to taxation at applicable slab rates. Moreover, for the purpose of taxation, there will be TDS or tax deducted at source under section 193 of the IT act. There is no tax liability on gains accruing from a government bond.
Ans. These are bond markets that deal with bonds of companies that are financially distressed. There is a high chance of default if issuers do not make timely payments of interest or principal. The yields from these bonds can be quite high as compared to other instruments to offset the risk of default.
Ans. These bonds have an inverse relationship with prevailing market interest rates. An increase in market rates will lead to depreciation in their value, and a decrease in market rates will lead to higher returns.
Ans. In India, only two government agencies, namely National Bank for Agricultural & Rural Development (NABARD) and Rural Electrification Corporation (REC), are eligible to issue zero coupon bonds as per government mandate.
Ans. Investors who wish to purchase bonds at a lower price than the prevailing prices in the market can invest in deep discount bonds. The discounted price helps to offset lower yields associated with the bond, and investors still get regular interest payments.
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