What is Discount Bond? Know in Detail

6 mins read

Have you ever wondered why your favourite brands go on sale? Why would your favourite brand sell that shirt for Rs 999 instead of Rs 3999? Why sell at discount? Well, for the most part – especially during the end of season sales – brands are keen to offload items that didn’t seem to have any takers, and items that are not coming back in style for the next season, meaning that they are unlikely to continue having takers in the future.

You as a shopper, therefore, need to ask yourself whether it makes sense to buy such items. Maybe you’re in the know and happen to have inside knowledge that a certain item is – contrary to popular belief – actually going to stay on-trend next season. Or maybe you feel like a sweater is a sweater, and you’ll use your discount purchase next winter. (Or maybe winter is over here, but not where you’re heading for your next remote working destination). Or maybe you’re just buying an item because it is a classic, or because you should have one such item in your closet. Some people don’t shop at sales at all because they believe that only what is undesirable is sold at a discount.

Discount bonds have similar fundamentals in terms of why they trade at a discount and the considerations/ reservations that buyers might have, as you will discover from the discount bond definition below.

What is a discount bond?

A discount bond is a bond that is trading on the stock market for a price that is lower than its face value. For example, maybe the face value of the bond is Rs 1500, but it is currently trading at Rs 1150. This would mean that it is a discount bond.

Why would bonds trade at a discount? Well very much like how apparel brands discount items that are not selling or that they foresee as having low demand in the next fashion season, bonds of companies that look like they might have trouble repaying their debts, might sell at a discount.

Now it is easy enough to define discount bond, but to fully grasp the concept, let us understand bonds and bond pricing factors:

What affects bond pricing on the stock market

When you buy a bond, you – the bondholder- become a creditor to the bond issuer – or the company/ government entity issuing the bond. This means that they owe you a debt and that they must repay you.

  • News

News around specifics such as the company, its sector of operation and even the components of its products can cause fluctuations in the bond’s price on the stock market. General market factors like demand and supply, oil prices, economic, political and social happenings might also affect the prices of bonds.

Anything that makes the bond issuer look more profitable and more likely to make good on their debts has the potential to drive the bond price up. Anything that positions the bond issuer as potentially unable to make good on their debt to bondholders, could well drive the bond price down.

  • Bond issuer

The government is usually seen as unlikely to default on payments and therefore government bonds are seen as having less default risk. One might expect less volatility in the pricing of these bonds. On the other hand, companies and corporations will typically see comparatively higher bond pricing volatility on the stock market.

  • Interest payout proximity

The prices of bonds will typically rise just before the scheduled interest payout, and fall after the payout happens.

  • Interest competitiveness

Let’s say company XYZ is issuing bonds and offering 10% interest. Ramesh is happy with this deal and purchases a bond.

At some point when Ramesh holds the bond, the market interest rates get higher. Most bond issuers are offering 12% interest. If Ramesh tries to sell his bond on the market at this time, its lack of competitive interest rates will mean less demand and Ramesh might have to sell it at a lower price than the face value.

Is discount buys an advisable investment?

You are reading this article to evaluate whether you should buy discount bonds. Like most things in the stock market, there is no blanket yes or blanket no. It depends.

Pros of discount bonds

  • There is potential for significant capital gains if the bond price turns around, or if the bond buyer is able to hold the bond until maturity (provided the issuer does not default).
  • One can expect to receive interest at regular intervals.
  • Bonds are also seen as a less risky investment than stocks because the bond issuer has to pay the face value of the bond upon maturity.

Cons of discount bonds

  • Highly discounted bonds might indicate a serious default risk. There are a lot of big brands with huge liabilities (that overshadow their huge revenue) hosting tremendously oversubscribed IPOs and issuing bonds that are similarly experiencing more demand than supply. Don’t fall for the “well known brand” argument and look at financial data instead.
  • Zero coupon bonds, which usually trade at a huge discount – and keep increasing in their price as maturity approaches – do not pay out any interest.
  • Similarly distressed bonds that are selling at a very huge discount might not bring paying interest regularly. Or they might simply be expected to not pay.

Evaluating a discount bond

  • A metric called Yield to Maturity can be used to determine the current market value of a bond. If you have invested in/ have online access to a financial calculator, this should be no problem.
  • Do your research about the financial health of the company. Check revenue versus liabilities, income versus expenditure, profits versus losses. Also, find out about any pending legal cases.
  • Research the sector and the competition to ensure that the company is ahead in the game and will not default on repayment and interest payouts.

Conclusion

Discount bonds could represent high risk but also a high possibility for potential earnings if the investor is able to make the correct predictions and selections.