What is a Deep Discount Bond?
A deep discount bond is a bond that sells at a price which is 20% or more below the face value of the bond, and carries a low rate of interest during the term of the bond.
How Does a Deep Discount Bond Work?
The investor purchases the bond at a price that is below face value. The bond may be purchased at a significant discount because the coupon rate is significantly less than the market rate, or because of perceived instability of the issuing firm. Since the coupon rate is significantly less than the market rate, the price paid for the bond by the investor is significantly lower as well. The discount factors the higher risk into the price.
A zero-coupon bond is similar, but such bonds do not offer any return during the life of the bond, and then pay the holder the face value at maturity only. The discount on a zero coupon bond represents the interest that will be paid, in its entirety, on the maturity date of the bond.
Why Does a Deep Discount Bond Matter?
Deep discount bonds allow investors to lock in a better rate of return for a longer period of time, since these bonds are not likely to be called. Investors also enjoy the leverage that comes with such investments. However, investors must be prepared since these bonds are typically higher risk.
