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Understanding Deep Discount Bonds

Want to know what a deep discount bond is? Why it is called a “deep discount” bond? Why is it also known as a zero-coupon bond? Read on.



In “What are bonds – Price, Coupon, Yield and more”, we saw what a bond is.

Now, let’s understand a special type of bond – the deep discount bond (which is also called a zero coupon bond).

What is a deep discount bond?

As the name suggests, a deep discount bond is a type of bond – this means that it is a fixed income instrument. Your investment in this bond gives you a fixed return.


Difference from a regular bond

So, how is a deep discount bond different from a regular bond? Here are a few differences:

- It is not issued at face value. In fact, it is issued at a discount to the face value.
- There is no coupon for these bonds. That is, these bonds bear a zero coupon rate, and have no periodic interest payment.

Well, if this is the case, how do you earn from these bonds? How is the interest paid to you? Let’s find out!

How does a deep discount bond work?

A deep discount bond is issued at a steep discount to the face value of the bond.

Thus, if the face value of the bond is Rs. 100, it is issued at a deep discount to it – say, at Rs. 65.

And on the date of maturity, when the bond is redeemed, the bond issuer pays you the face value of the bond.

Yes, you read it right – the bond is issued at a discount to the face value, and is redeemed at its face value.


The reason for zero coupon

You would probably guess why there is no coupon on these bonds – the difference between the issue price and the face value of the bond is the interest that you earn on your investment!

You don’t earn a periodic interest on these bonds in the form of the coupon, therefore these bonds are also known as Zero Coupon Bonds.

Note: This also means that unlike regular bonds, there is no periodic income from these bonds. You get all the interest at the time you redeem the bond. So, it is like the cumulative option in a fixed deposit (FD).

(Please read “Fixed Deposit (FD) – A favourite for generations” for more on fixed deposits)

What is the rate of return?

For normal bonds, the calculation is easy – you earn a return equal to the coupon if you buy the bond at the face value. If you buy the bond from the market, your rate of return is the yield at the time of the purchase.

But there is no coupon for deep discount bonds – how do you calculate the return?

(Confused by all these terms? Please read “What are bonds – Price, Coupon, Yield and more”)

As we saw before, the return is the difference between the issue price at which you buy the bond, and the face value of the bond – which is the price at which the bonds are redeemed.

This is the total return that you get from your investment – the yearly rate of return in percentage (%) can be derived using the formula we learnt for finding the compound annual growth rate (in “What is Compound Annual Growth Rate (CAGR)?”):

A = P * ( ( 1 + r ) ^ n )

Where

A = Final Amount
P = Principal amount
r = Rate of interest, expressed in %
n = Number of years

Let us understand this using some examples.


Example 1

Let’s say you buy a deep discount bond at Rs. 60. Its face value is Rs. 100, and the tenor is 10 years.

So, in our example,

A = Rs. 100
P = Rs. 60
n = 10

‘r’ is the rate of interest that we want to find. Using the formula, we get:

r = 5.24%

Thus, your rate of return in this case is 5.24% per year.

Example 2

You buy a deep discount bond at Rs. 35. Its face value is Rs. 100, and the tenor is 15 years.

So, in this example,

A = Rs. 100
P = Rs. 35
n = 15

Using the formula, we get the rate of interest:

r = 7.25%

Thus, your rate of return in this case is 7.25% per annum.

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