A discount bond is either a bond that was originally sold at less than its face value, or which now trades at a price below its face value (or both). Depending on the circumstances, a discount bond can represent a buying or selling opportunity for an investor.
A bond sells at a discount to its face value for one of the following reasons:
- Interest rate differential. The current market interest rate is higher than the interest rate being paid by the issuer, so investors pay less for the bond in order to derive a higher effective interest rate on their investment.
- Default risk. Investors perceive the issuer as being at risk of not redeeming the bonds it has issued, and so are willing to sell their bonds at a reduced price in order to avoid the risk of default.
- Credit rating reduction. When a bond rating agency reduces the credit rating of an issuer, this can trigger a high volume of selling by investors on the secondary market, which lowers the price of a bond; this is a similar issue to the preceding default risk comment.
A bond may sell at a deep discount to its face value if the interest rate paid by the issuer is much lower than the market interest rate. The discount is especially deep when the issuer sells zero-coupon bonds, where investors must rely upon the size of the discount in order to earn any effective interest rate (since the issuer is paying no interest).
Any discount bond will gradually increase in price as its redemption date approaches, since the issuer always repays the face value of the bond; that is, no bond is repaid at a discount from its face value.
An investor may buy bonds that are selling on the secondary market at a discount, not to obtain a high rate of interest, but rather to exercise control over the issuer. This circumstance can arise when the issuer is experiencing financial difficulties, so its bonds are selling at such a low price that an investor can buy up a large amount of the distribution for a minimal investment. This variation is particularly likely when bonds are convertible into company common stock, so that investors can buy bonds with the intent of acquiring shares in the issuer at a low price.