Definition
The financial accounting term deep discount bonds refers to indentures that are sold at a price significantly lower than face value, typically 20% or more. Deep discount bonds can also include zero coupon bonds, which do not pay a rate of interest to the holder.
Since deep discount bonds are usually issued for a term of five years or more, they represent a long term obligation of the company, and are shown in the long term liabilities section of the balance sheet.
Explanation
Issuing long-term bonds represents an important source of financing for many large companies. Deep discount bonds typically carry maturities of five years or longer and are classified as long-term debt obligations. (Treasury bills are one exception to the above rule, maturing in as few as 28 days.)
Generally, deep discount bonds take one of two forms:
Interest Bearing Debt: these indentures provide the investor with periodic interest payments; however, the security is sold at a discount of 20% or more from the bond's par value. This can occur because the coupon rate on the bond is considerably lower than prevailing rates offered by securities of similar risk. This will oftentimes happen when interest rates are rising, whereby newly issued securities carry higher coupon rates. A deep discount can also be the result of an increase in the risk of non-payment, or credit risk.
Zero Coupon Bonds: these securities do not provide the investor with periodic interest payments. Instead, they are sold at a discount to par value, and provide the investor with a return as calculated by its yield to maturity. Zero coupon bonds are favored by investors that do not need a near term source of income, but have a longer-term goal. Since this bond's yield is solely based on the difference between the market price and its face value, its price will fluctuate more than bonds that provide periodic interest payments too.
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