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What is a Discount Bond or Zero-Coupon Bond?
By Bajaj Broking Team
February 16, 2024
5 mins read
Authorized Person
A discount bond is a type of bond that is sold below its face value. Essentially, when you buy a discount bond, you are buying a bond at a discounted price, and you will receive the face value of the bond at maturity. In other words, you are paying less than the full price of the bond upfront, and the difference between the purchase price and the face value is essentially the bond's interest.
A similar term is deep discount bonds, also known as zero-coupon bonds because they do not make any periodic interest payments. Instead, deep discount bonds are issued at a deep discount, and the investor receives the face value of the bond at maturity.
How does a Discount Bond Works?
When you purchase a discount bond, you are essentially buying the bond at a discounted price. For example, if a bond has a face value of Rs 1,000 and is selling at a discount of 10%, you would pay Rs 900 to purchase the bond. At maturity, you would receive the full face value of the bond, which is Rs 1,000. The difference between the purchase price and the face value is essentially the bond's interest.
How is the price of Zero Coupon Bond Calculated?
The price of a zero coupon bond can be calculated using a simple mathematical formula. However, the formula will change slightly depending on whether you’re calculating the price of the bond annually or semi-annually. Here’s an overview of how you can calculate the price of a zero coupon bond on an annual and semi-annual basis.
Formula for Calculating the Price of a Zero Coupon Bond on an Annual Basis
Price of a Zero Coupon Bond = Face Value ÷ (1 + r)n
Here,
Face value represents the value of the bond on maturity, r represents the interest rate and n represents the number of years to maturity.
Formula for Calculating the Price of a Zero Coupon Bond on a Semi-Annual Basis
Price of a Zero Coupon Bond = Face Value ÷ [1 + (r ÷ 2)n*2
Here,
Face value represents the value of the bond on maturity, r represents the interest rate and n represents the number of years to maturity.
Interest Rates and Discount Bonds
Discount bonds are affected by changes in interest rates. When interest rates rise, the value of a discount bond falls because investors can earn higher interest by purchasing new bonds at higher interest rates. Conversely, when interest rates fall, the value of a discount bond rises because investors are willing to pay more for the bond in order to lock in a higher interest rate.
Reasons for Bond Price Fluctuations During Trading
Bond prices can fluctuate due to a variety of factors including:
- Changes in interest rates
- Changes in the issuer's credit rating
- Changes in supply and demand
For example, if interest rates rise, the value of a bond will fall because investors can earn higher interest by purchasing new bonds at higher interest rates. Similarly, if the issuer's credit rating is downgraded, the value of the bond will fall because investors perceive the issuer as a higher risk.
Additional Read: What is a Straight Bond?
Why are Bonds sold at a Discount?
Bonds are sold at a discount for a variety of reasons, including changes in interest rates, changes in the issuer's credit rating, and changes in market conditions.
Pros and Cons of Discount Bond
Discount bonds are bonds that are sold below their face value, or par value. Here are some pros and cons of discount bonds:
Pros
- Lower purchase price : One of the biggest advantages of buying a discount bond is that it is sold at a lower price than its face value. This means that investors can purchase the bond for less than its future repayment value, making it an attractive investment.
- Higher yield : Another advantage of discount bonds is that they typically offer a higher yield than bonds sold at face value. This is because the bond issuer is essentially borrowing money at a lower interest rate, and so they compensate investors by offering a higher yield.
- Capital appreciation potential : If interest rates decline, the market value of discount bonds may increase, providing a capital appreciation potential for investors.
Cons
- Lower interest payments : The main disadvantage of discount bonds could be that they typically pay lower interest payments than bonds sold at face value. This is because the bond issuer is borrowing money at a lower interest rate, and so they do not need to pay as much in interest payments.
- Risk of default : Discount bonds are often issued by companies with lower credit ratings, making them comparatively riskier than bonds issued by more financially stable companies. If the issuer defaults on the bond, investors may lose their entire investment.
- Higher tax liability : Investors in discount bonds may face higher tax liabilities than investors in bonds sold at face value. This is because the difference between the purchase price and the face value of the bond is considered a
Difference Between Zero-Coupon Bonds and Regular Bonds
The table below outlines some of the crucial differences between zero-coupon bonds and regular bonds.
| Particulars | Zero-Coupon Bonds | Regular Bonds |
|---|---|---|
| Issue Price | Issued at a deep discount from its face value | Issued at its face value |
| Interest Payments | Interest is not paid out to the investors | Interest on the face value of the bond is paid out to the investors regularly |
| Returns | Difference between the issue price and the redemption face value is the returns for an investor | Interest payments on the bond constitute is the returns for an investor |
| Volatility | More volatile compared to regular bonds | Less volatile compared to zero coupon bonds |
Additional Read: What are Commodity-Backed Bonds
Final Thought
Discount bonds can be an attractive investment option for investors looking for higher yields, particularly in a rising interest rate environment. However, it is important to understand the risks associated with investing in discount bonds, including the inherent risk of investing in lower-rated bonds and the lack of regular cash flow from the bond. As with any investment, it is important to carefully consider your investment objectives and risk tolerance before investing in discount bonds.
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Published Date :
16 Feb 2024
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