Discount Bond

A discount bond is a bond that trades on the secondary market for a price lower than its par value (also known as face value). Think of it like finding a crisp $100 bill on sale for $95. At the bond's maturity date, the issuer pays you the full $100, so you pocket the $5 difference on top of any regular interest payments. This price difference represents a capital gain. Why would a bond sell for less than it’s worth at maturity? The two main culprits are rising interest rates and increased perceived credit risk of the issuer. When market interest rates rise, older bonds with lower fixed coupon rates become less attractive, so their price must drop to offer a competitive overall return, or yield to maturity (YTM). Alternatively, if the issuing company's financial health deteriorates, investors demand a higher return for the added risk of default, which also pushes the bond's price down. For a value investing practitioner, discount bonds can present a fantastic opportunity to lock in an attractive yield with a built-in margin of safety—if you can tell a true bargain from a sinking ship.

A bond's price isn't static; it fluctuates in the market after it's issued. Understanding why a bond’s price drops below its face value is key to knowing if you're getting a deal or catching a falling knife.

Imagine a seesaw. On one end, you have interest rates, and on the other, you have bond prices. When one goes up, the other goes down. Let’s say you own a $1,000 bond that pays a 3% coupon ($30 per year). Suddenly, the central bank raises interest rates, and new, similar-quality bonds are now being issued with a 5% coupon ($50 per year). Your 3% bond looks pretty dull in comparison. To entice someone to buy your bond, you have to sell it at a discount—say, for $960. The new buyer still only gets $30 a year in coupons, but they also get a guaranteed $40 profit when the bond matures at $1,000. This combination of coupon payments and capital gain makes its overall yield competitive with the new 5% bonds.

The second major reason is a change in the issuer's creditworthiness. When you buy a bond, you're lending money. If the borrower's financial situation looks shaky, there's a higher chance they might not pay you back.

• Credit Downgrades: If a credit rating agency like Moody’s or S&P downgrades a company, it’s a signal that its financial health has weakened.
• Investor Demand: To compensate for this higher risk of default, investors will demand a higher potential return. The only way to increase the return on an existing bond is to lower its price. A bond from a financially troubled company might trade at a very steep discount, becoming what is known as distressed debt.

For a value investor, a discount bond can be a dream come true, but it requires careful homework. The goal is to find a bond that is cheap for the right reason.

1. The Opportunity: The best-case scenario is finding a bond from a high-quality, financially stable company that is trading at a discount simply because market interest rates have risen. The company's ability to pay its debt hasn't changed. Here, the discount provides a wonderful margin of safety. You're buying a reliable promise to be repaid in full, but at a bargain price, locking in a higher yield to maturity.
2. The Value Trap: The danger lies in bonds that are cheap because the issuer is circling the drain. A bond trading at 50 cents on the dollar might seem like an incredible deal, but if the company goes bankrupt, that bond could become worthless. Chasing the high yield of distressed debt without deep expertise is one of the quickest ways to lose your principal. Always ask: Is this cheap because the market is pessimistic, or because the company is actually failing?

Some bonds are born to be discount bonds. The most common type is the zero-coupon bond. These are the ultimate in simplicity and are often considered a type of deep discount bond. A “zero” works exactly as the name implies: it pays zero coupons. Your entire return comes from the difference between the discounted purchase price and the full par value you receive at maturity. Example: You might buy a 10-year, $1,000 par value zero-coupon bond for $750 today. You will receive no annual interest payments. Instead, you simply wait 10 years and collect your $1,000. Your profit is the $250 difference, which represents the compounded interest you earned over the decade. This makes them highly predictable investments, provided the issuer (often a government) is creditworthy.