Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Discounted Bonds: 3 Reasons Why They're Not As Great As They Sound

My old accounting professor clued me into a lesson about sales.

If a retailer offers a sale on a product on a regular basis, that's the real price. When you don't buy the same item on sale, you're paying an inflated price.

With bonds, however, it gets a little more complicated. When I buy a shirt, I know how it's going to look on me and what pants I'll pair it with. I'll also probably wear it within a couple of weeks of the purchase date.

But buying bonds isn't like buying that shirt:  It can be a very long time before you are able to fully benefit. After all, they may not reach maturity -- the day it can be cashed out at full value -- for 10 or 15 years. 

And that's just one reason to think twice about buying discounted bonds. There are other very good reasons. Here are three more:

1. That Discount May Not Be Much Of A Bargain.

Let's say you buy a bond with a $1,000 face value for $500 and the bond reaches maturity on June 30, 2023.
In other words, it will take 10 years before you're guaranteed the $1,000. In the meantime, you don't have your $500.

The usual reason for a bond to be sold at a discount is the fixed interest rate is lower than what's being offered in the current market. The number of percentage points of difference varies widely. Think about your mortgage. You could score a 4.5% rate now, while 7% was considered a good deal just five years ago. 

Compare the interest rate you're currently earning on other investments. For instance, if you're averaging a 5% annual rate of return on $500, you'd have over $800 by the end of 10 years. So if you got a 50% deal on the bond, it would be worth it. If you bought a $1,000 bond for $750, the bond may not be worth investing in.

2. If The Company Goes Away, Your Money Probably Does, Too.

If you're buying a bond -- discounted or not -- be sure to think about the stability of the company whose bond you're buying. If you're purchasing a federal government bond, this isn't an issue. (After all, if the federal government went bankrupt, we'd all have bigger worries than one bond's stability.) But if you buy a corporate bond, you have to count on the company being around when your bond hits maturity. If the company goes belly up before your bond hits maturity, more than likely your bond will, too.

If your bond matures in 10 to 15 years, that's a big prediction to make. It's a slightly easier decision if you bought the bond with less than five years until maturity.

3. Interest Rates Aren't The Only Reasons Bonds Are Discounted.

Sometimes the discount is due to the perceived risk of the company. A company that's issuing bonds that isn't in the best financial state could issue bonds at a discount in order to get the money it needs, says Michael Eisenberg, CPA and personal financial specialist.

A bond is simply a loan product for a specific number of years at a specific interest rate. It may be that if you're going to take the risk of buying a bond from a company that's shaky financially, you might be better off buying stock -- if the company succeeds, you could gain more profit, more quickly.

The Investing Answer: Discounted corporate bonds are way too risky to invest in without help from a financial professional. And a financial professional can help you weigh the value of government bonds versus other investments over the time period until maturity.