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Deep Discount Bonds: Working, Calculation and Example

Governments or corporations issue bonds to raise funds for specific purposes. Bonds offer regular interest payment at predetermined intervals and return of the principal amount at the end of the maturity period. Deep discount bonds are offered at a much lower face or par value. These bonds offer a return greater than the amount received by other bondholde₹ Learn about it in detail.

What Is A Deep-Discount Bond? 

Deep discount bonds are offered at a minimum of 20% lower rate than the face value. These bonds have significantly higher yields than other similar fixed-income securities. Higher yields and lower rate of interest is because issuers of these bonds are not that credible. Also, their ability to pay interest and principal on time is quite low.

Deep Discount Bonds Working

Deep discount bonds come with risks. Hence, the discount is offered to make them seem more lucrative. Hence, the higher the risk, the higher the discount is offered. Junk bonds make an ideal example of these bonds.

The value offered is usually lower by 20% or more than the face value. These bonds are also issued at a considerable discount if the primary coupon rate on the bond is steeply lower than the prevailing rate of interest. This is because investors might find these bonds less desirable for their low coupon rate.

Calculation of Deep Discount Bonds

Let’s understand how deep discount bonds work with the help of an example:

Suppose you invested in a bond with a face value of ₹20,000. It has a coupon rate of 10% per year. The maturity period of this bond is 2 years.

You can calculate the price of deep discount bonds by using the formula given below:

P = F/ (1+r)^h

Here, P indicates the price of the bonds

F signifies the face value of the bond

“r” indicates the discount rate offered by the issuer.

“h” is the holding or maturity period.

Putting the values in the formula, we get;

P or Price of the bond = 20,000 / (1+10)^2 = 20,000/ 121 = ₹165.28

Example of Deep Discount Bond

Following are some examples of deep-discount bonds:

1.      NABARD Deep Discount (Bhavishya Nirman Bonds)

Also known as NABARD Bonds, these were issued at ₹9250 for investment amounts above  5 crore and ₹9300 for investment amounts lower than ₹5 crore. These had a maturity value of ₹20,000 after 10 years. The YTM ranged around 8.01% and 7.95% for the investment amounts, respectively.

2.      IDBI Deep Discount Bonds

The Industrial Development Bank of India (IDBI) first offered deep discount bonds in 1992. They had a holding period of 25 years. They were priced at ₹2700 with a face value of ₹1 lakh. The YTM was 15%.

3.      ICICI Bank’s Ashirwad Deep Discount Bond

These were the second deep discount bonds issued in 1996 and had a face value of ₹2,00,000. The discounted price was ₹5200 and the holding period was 25 years. Upon maturity, they were redeemed at their face value of ₹2 lakhs.

What Are NABARD Bonds?

NABARD or National Bank of Agriculture and Rural Development launched deep discount bonds. As they were launched by government institutions, they had low credit risk. The face value of these bonds was ₹1000 and you can start investing with a minimum of ₹5000.

The coupon rate varies depending upon their tenure. The biggest advantage of these bonds is that the interest earned does not attract any tax under the Income Tax Act. Also, they have high liquidity and you can easily track them on stock markets. Additionally, you can keep these stocks in hard copy format. Apart from that you do not need to open a Demat account for it and pay additional charges.

What Are the Advantages of Deep Discount Bonds?

The following are some advantages of deep discount bonds:

 1. Profitable Returns

Deep discount bonds offer considerably higher returns than other bonds as they are sold at a discounted price than their face value. Hence, the difference between the face value and the purchase value is the profit for the investor.

2. Tax Benefits

Deep discount bonds come with tax benefits. You don’t have to pay tax on the interest earned. However, the maturity amount received at the end of tenure is eligible for taxation. This can be beneficial, especially for higher tax brackets.

3. Easy Way of Investment

You can invest in these bonds without the assistance of brokers or underwriters.  Also, you don’t need a Demat account. This can save a bunch of additional costs.

4. Portfolio Diversification

You can start investing in these bonds to diversify your portfolio if you already invest in stocks, mutual funds, or other investment instruments. You can mitigate risk by investing in these bonds if your portfolio includes some high-risk instruments.

5. Long-term Investment

Deep discount bonds come with long investment tenures. To make the most of these investments, investors can reinvest the interest amount, resulting in higher returns. 

 6. Lower Risk

Deep discount bonds are comparatively less prone to risk than traditional bonds. This is due to the fact that these bonds are not subject to interest rate fluctuations. They are less volatile and more predictable.

What Are the Disadvantages of Deep Discount Bonds?

Now that you know the benefits of investing in deep discount bonds, you should check out the drawbacks as well to make a sound investment decision:

1. Inflation Risk

Inflation can highly affect the price of a deep discount bond. A bond’s face value inversely proportional to inflation. This indicates that an investor might not be able to purchase as much with the returns as they could at the time of purchasing the bond. 

2. Taxation Risk

Deep discount bonds are taxed differently than traditional bonds. Tax is applicable on the returns which is the difference between purchase and face value. This is applicable even if you do not receive any interest payment. Therefore it can result in higher tax payments for the investor.

3. Default Risk

These bonds are usually issued by small, and less credible companies. This means they are at higher risk of default. If the bond issuer defaults on the bond, you are at the risk of losing an entire investment.  

4. Liquidity Risk

Deep discount bonds have comparatively lower liquidity than other bond types. Hence, if you are willing to sell the bond before maturity tenure, you may not receive the whole face value or not be able to sell it in an instant.

Deep-Discounts vs. Zero-Coupon Bonds

Even though deep discount and zero coupon bonds share similarities, they have some foundational differences. Here are those:

Deep Discount BondZero Coupon Bond
Deep discount bonds are offered at a discounted purchase value but they have a coupon rate.Zero coupon bonds are also offered at discounted prices but they do not have any coupon rate.
Deep discount bonds’ maturity dates may vary.Zero coupon bonds come with a fixed maturity tenure.
You have to pay taxes on your returns e.g., the difference between subscription and face value.Only capital gains are eligible for taxation.

Conclusion

Deep discount bonds are a popular investment option due to their significant chances of capital appreciation. They are also high-risk due to low credibility. Hence, you should conduct thorough market research before investing in these bonds and keep the risk factors in mind.

FAQs

Are deep discount bonds taxable?

Yes, the difference between subscription and face value or the return of deep discount bonds is taxable.

What is another name for a deep discount bond?

Deep discount bonds are also known as pure discount or zero coupon bonds.

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