Introduction
A discount bond is a bond that is sold at a price lower than its face value (par value). This happens when a bond's market price declines due to falling demand, rising interest rates, or lower credit ratings of the issuer.
In India, discount bonds are commonly found in government securities (G-Secs), corporate bonds, and municipal bonds traded in the secondary market. When a bond trades significantly below its face value (usually 20% or more), it is classified as a deep-discount bond.
Investors buy discount bonds for capital appreciation, as they can redeem them at full par value upon maturity, generating profits. However, these bonds also carry risks such as interest rate fluctuations and credit risk.
This article explores discount bonds, deep-discount bonds, reasons for their pricing, advantages, risks, and their role in the Indian bond market.
What Is a Discount Bond?
- A discount bond is a bond that trades at a price below its face value (par value) in the secondary market.
- If a ₹1,000 face value bond trades at ₹950, it is a discount bond because it sells for less than its par value.
- If the bond falls 20% or more below par value (e.g., ₹800 for a ₹1,000 bond), it is called a deep-discount bond.
Investors purchase discount bonds to take advantage of price appreciation, as the bond price moves closer to par value upon maturity.
Why Do Bonds Trade at a Discount?
Several factors influence why a bond is priced below its par value in the secondary market:
1. Rising Interest Rates
- When interest rates increase, new bonds are issued with higher coupon rates, making older bonds less attractive.
- Investors demand a discount on old bonds to match the higher returns of new bonds.
- For example, if the RBI raises repo rates, older bonds with low interest rates decline in price.
2. Credit Risk and Downgrade
- If a bond issuer faces financial instability, its credit rating is downgraded.
- Investors sell the bond, causing its price to fall below par value.
- For example, a corporate bond rated AAA may drop to BBB, leading to a price discount.
3. Market Liquidity Issues
- If a bond has low demand or fewer buyers, it may trade at a discount due to liquidity constraints.
- Government bonds (G-Secs) usually have better liquidity than corporate bonds.
4. Economic Recession and Investor Sentiment
- In uncertain markets, investors prefer safer investments like gold and fixed deposits.
- Bonds with low market confidence may fall into discount territory.
- For example, during the COVID-19 pandemic, several corporate bonds were traded at a discount due to uncertainty in business growth.
Types of Discount Bonds
1. Regular Discount Bonds
- Bonds that trade slightly below face value due to changing interest rates or market conditions.
- Example: A 10-year government bond with a 6% coupon rate trading at ₹980 instead of ₹1,000.
2. Deep-Discount Bonds
- Bonds that trade at a significant discount (20% or more below par value).
- Example: A corporate bond issued at ₹1,000 now trading at ₹750 due to financial stress in the company.
3. Zero-Coupon Bonds (ZCBs)
- Bonds issued without interest payments (coupons) but sold at a deep discount.
- Example: A ₹1,000 zero-coupon bond issued at ₹700 and redeemed at ₹1,000 upon maturity.
Advantages of Investing in Discount Bonds
1. Potential for Capital Gains
- Discount bonds provide higher profits when they mature at full par value.
- Example: Buying a ₹1,000 bond at ₹900 and redeeming it at ₹1,000 gives a ₹100 gain per bond.
2. Lower Market Price Entry
- Investors can buy bonds at a lower price compared to new bond issues.
- Long-term investors benefit from price appreciation.
3. Less Risk Than Stocks
- Even discounted bonds pay back full principal at maturity, unlike stocks that may fall indefinitely.
- Government discount bonds are safer than corporate discount bonds.
4. Diversification Benefits
- Investing in discount bonds reduces portfolio volatility, balancing stock investments.
- For example, deep-discount government bonds are considered a safe hedge during economic downturns.
Risks of Discount Bonds
1. Interest Rate Risk
- If interest rates continue rising, bond prices may drop even further.
- Long-duration bonds face higher interest rate risk.
2. Credit Risk and Default Risk
- A company or government facing financial trouble may fail to repay bondholders.
- Deep-discount bonds with low credit ratings have a higher risk of default.
3. Liquidity Risk
- Some corporate bonds have fewer buyers, making them harder to sell before maturity.
- For example, small-cap corporate bonds in India may trade at a discount due to low investor demand.
4. Reinvestment Risk
- If a discount bond is redeemed early, investors may struggle to find equally profitable investments.
How to Invest in Discount Bonds in India?
1. Buy Government Discount Bonds (G-Secs)
- Available through RBI Retail Direct, NSE, and BSE.
- Ideal for low-risk, long-term investors.
2. Invest in Corporate Discount Bonds
- Check bond ratings from CRISIL, ICRA, and CARE Ratings.
- Invest in well-rated companies to reduce credit risk.
3. Consider Zero-Coupon Bonds
- Best for investors looking for long-term capital appreciation.
- Offered by Government of India, PSU financial institutions, and corporate issuers.
4. Invest Through Debt Mutual Funds
- Mutual funds invest in discount bonds, offering diversification and professional management.
- Examples: Gilt Funds, Dynamic Bond Funds, and Corporate Bond Funds.
Conclusion
Discount bonds provide an opportunity for investors to purchase bonds below face value and earn capital gains upon maturity. They are commonly found in government and corporate bond markets and are influenced by interest rate changes, credit risk, and liquidity factors.
Investors must carefully evaluate bond ratings, interest rate trends, and issuer stability before investing in discount bonds. While they offer high returns, they also carry risks, making them suitable for informed and risk-tolerant investors.
With India’s bond market growing rapidly, discount bonds remain an attractive investment option for those seeking long-term capital appreciation.
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