The term bonds issued at a discount refers to newly issued debt that is sold at a price that is less than its par value. When a bond is issued at a discount, the company will typically choose to amortize the discount over the term of the bond using a straight-line method.
Workings of Bonds Issued at a Discount
Bonds can sell at a premium or discount to par value due to administrative delays in getting the offering to market.
Issuing long-term bonds represents an important source of financing for many companies. When a corporation prepares to issue bonds to investors, they determine an acceptable coupon rate, which reflects both the prevailing rate of interest and the creditworthiness of the company.
The process of issuing bonds to the public takes a considerable amount of time. Approval is needed from the Securities and Exchange Commission, a prospectus must be written, and underwriting of the securities might be arranged.
This delay, along with changes in variables such as prevailing interest rates or the creditworthiness of the issuing company, can result in the bonds selling at a discount to their face value. As a general rule of thumb, the price of a bond will move inversely with interest rates.
If a bond is sold at a discount, the shortfall is referred to as a discount on bonds payable. Companies will typically choose to use a straight-line method to amortize this discount over the term of the bond.
Company A issued $5,000,000 in bonds with a coupon rate of 4% and a term of 15 years. The Federal Reserve increased interest rates slightly as Company A prepared the public offering of these securities. For this reason, the bonds were sold at 0.97, which is 97% of the par value.
The journal entry to record the issuing of the bonds at a discount would be:
| Debit | Credit | |
|---|---|---|
| Cash ($5,000,000 x 0.97) | $4,850,000 | |
| Discount on Bonds Payable | $150,000 | |
| Bonds Payable | $5,000,000 |
Using the straight-line method, Company A would amortize the discount over a period of fifteen years. The journal entry for this transaction is as follows:
| Debit | Credit | |
|---|---|---|
| Interest Expense | $10,000 | |
| Discount on Bonds Payable ($150,000 / 15 years) | $10,000 |
As noted in the above journal entry, selling the bond at a discount effectively increases the interest expense of the issuing company.
Pros and Cons of Discount Bonds
- Lower initial investment required
- Potential for higher yield at maturity
- Stable and predictable income, albeit low
- Capital gains opportunity, particularly with deep discount bonds
- Higher risk of default or credit risk
- Lower coupon rate than prevailing market rates
- Can depreciate if market rates continue rising
- Possibility of limited liquidity in the secondary market
Discount Bonds Considerations
Consumers love a good discount. What’s wrong with getting something below its initial price?
Well, in the world of investing, nothing is ever that simple. Getting a discount bond may seem like a good opportunity to earn, but one must ask, why does a bond get discounted in the first place?
Here are the most important considerations investors need to think about before deciding whether or not they should purchase a specific discount bond.
Coupon Rates
Besides capital preservation, one of the main reasons investors invest in bonds is to secure a stable income. Most bonds have fixed income rates, called coupon rates, which determine the regular interest payments bondholders receive.
While their reduced price can provide a higher effective yield, the coupon rates of discount bonds are typically lower than the prevailing market rates.
This is also one of the main reasons why bonds get discounted. Unable to compete with the rates other bonds offer, issuing companies offer their bonds at a discounted price to attract investors despite the lower potential for income through coupons.
This means that the lower interest payments paid by discount bonds may not be ideal for investors seeking to secure a stable income through their investments.
On the other hand, when a discount bond reaches maturity, the investor who holds it receives the full face value of the bond, even though they bought it at a reduced price. This presents a great capital appreciation opportunity for investors with a higher risk appetite willing to forgo immediate income in exchange for potential long-term gains.
In summation, while most bonds are considered a suitable investment for conservative and income-seeking investors, discount bonds are quite the opposite.
Market Interest Rates
As we already mentioned, discount bonds have a direct correlation to the price movements of the prevailing market interest rates.
Let's say a bondholder owns a bond with a coupon rate of 3% while the prevailing market interest rates have risen to 5%. In such a scenario attracting potential buyers might be difficult for the bondholder, as investors can obtain higher yields by purchasing bonds with coupon rates closer to the prevailing market interest rates.
To make their bond more competitive and enticing, the bondholder may need to sell it at a price lower than its face value. By selling the bond at a discount, the bondholder aims to compensate for the lower coupon payments compared to other bonds available in the market.
So, for example, if the bondholder’s bond was initially purchased for $1,000, they might sell it on the secondary market for $950. If an investor buys the bond at the discounted price of $950, they will receive the bond's face value of $1,000 at maturity.
The $50 discount, when considered alongside the 3% coupon rate, would contribute to a higher effective yield for the investor compared to if they were to buy a bond at its face value with a similar coupon rate. However, it may not fully offset the lower coupon payments compared to bonds with coupon rates closer to the prevailing market interest rates.
Whether or not the extra $50 will be enough to compensate for the lower coupon payments depends on the specific circumstances and investor preferences.
If the prevailing market interest rates continue to increase after the bond has been sold, the buyer of the bond may face challenges in terms of opportunity cost. They could have potentially invested in bonds with higher coupon rates that became available after their purchase. In this case, the buyer may have missed out on higher yields and may perceive their decision as less favorable.
On the other hand, if the prevailing market interest rates subsequently decrease, the buyer of the bond may benefit. They would have locked in a higher yield through the discounted purchase price of $950, while the coupon rate remains fixed at 3%. If market rates decline, the bondholder may view their decision to purchase the discounted bond as advantageous.
YTM Estimations
YTM, or yield to maturity estimation, is a measure commonly used by investors to calculate the total return they can expect to earn from a bond if it’s held until maturity. It can be a useful tool for assessing potential bond investments as it takes their current market price, face value, coupon rate, and the time remaining until their maturity into account.
YTM estimations use a formula that assumes that the bond pays fixed periodic coupon payments, which are reinvested at an equal yield over its remaining term until maturity. It’s a relatively complex calculation though there are plenty of financial calculators available online that can be used to perform it easily.
That being said, YTM calculations involve assumptions and are based on various factors, including market interest rates and reinvestment rates. This is why the numbers they provide are estimates and should only be used to evaluate bonds, rather than for definitive predictions of actual returns.
Nevertheless, investors interested in purchasing discount bonds can certainly use YTM estimations to assess the attractiveness of bonds with different characteristics and determine which ones offer the most favorable yield given the prevailing market conditions.
Risk of Default
Discount bonds do carry a risk of default, similar to any other bond. However, the specific nature of discount bonds, where a significant portion of their value relies on the return at maturity, can make default risk an even more important consideration for investors.
When purchasing a discount bond, investors expect to earn a return by holding the bond until maturity and receiving the full face value. This is the main selling point of discount bonds. The discount represents a reduction in the purchase price, creating the potential for higher returns if the bond is held to maturity. However, this return is contingent upon the issuer fulfilling its payment obligations.
If the issuer defaults and is unable to repay the full face value of the bond at maturity, the investor's expected return may not materialize. In such a scenario, the discount that was initially applied becomes insignificant, as the investor would suffer a loss of capital.
Therefore, it’s crucial for investors to carefully evaluate the creditworthiness and financial stability of the bond issuer when considering discount bonds.
Distressed and Zero Coupon Bonds
Bonds issued by companies with lower credit ratings or weaker financial positions generally carry a higher risk of default. This risk can be influenced by factors such as the issuer's financial health, economic conditions, industry trends, and regulatory environment.
Bonds with longer maturities are generally considered to carry a higher risk of default compared to bonds with shorter maturities. Long-term bonds can indicate financial distress, and the longer the bond's maturity, the more time there is for unforeseen events or changes in the issuer's financial situation to increase the risk of default.
Bonds issued by financially distressed companies are commonly known as distressed bonds. These bonds typically have a higher risk of default compared to bonds issued by financially stable companies, making them speculative investments.
However, distressed bonds often come with significant discounts of 20% or more, which makes them attractive to investors willing to take on higher risks in exchange for the potential for higher returns.
One popular type of bond with large discounts is zero-coupon bonds. These bonds are issued at a significant discount to their face value and do not pay regular coupon payments.
Investors interested in purchasing zero-coupon bonds have unique considerations regarding default risk. Since there are no coupon payments to partially offset the risk of default, the investor's return is entirely dependent on the issuer's ability to repay the face value of the bond at maturity. If the issuer defaults, the investor may face a complete loss of capital.
Discount vs Premium Bonds
Premium bonds are also bonds that are sold at a different price than their face value, but in contrast to discount bonds, they are sold at a higher price.
Essentially, they are the opposite of discount bonds in the context of the coupon rates they provide. They are bonds that have larger coupon rates than the prevailing market rates and can secure a stable regular income for conservative investors.
At maturity, premium bonds are redeemed at their face value, which is higher than the price paid by the investor. This means that investors will receive a lower effective yield compared to the coupon rate, as the premium paid reduces the overall return on investment.
Premium bonds are usually issued by financially stable and creditworthy entities, making their risk of default very low. However, there are other risks, like opportunity costs, and the chance of overpaying the premium in specific market conditions related to them as well.
Neither premium nor discount bonds can be definitively categorized as more profitable or riskier compared to each other, as it all depends on various external factors. However, each type of bond is more suitable for a specific type of investor or investment strategy.
