When Is It a Good Investment to Buy Discounted Bonds?

Bonds are debt instruments used by corporations and governments to borrow money. An investor purchasing a bond lends money to the issuer, receiving regular interest payments and the principal at a predetermined maturity date. This principal, or par value, is typically $1,000 for corporate bonds.

Though bonds are often issued at par, their market price fluctuates. A bond selling at a discount means its market price is below face value. Acquiring such bonds can be an attractive investment. This article explores when purchasing discounted bonds is favorable.

Defining Bond Discounts

Understanding discounted bonds requires grasping core terms. The par value, or face value, is the amount the bond issuer repays at maturity, typically $1,000. The coupon rate is the annual interest paid on its par value, usually semi-annually. The maturity date is when principal is repaid and interest payments cease.

A bond’s market price, traded in the secondary market, fluctuates daily. It trades at par when its market price equals face value, aligning its coupon rate with current market rates. A bond trades at a premium when its market price is higher than par, often due to a more attractive coupon rate than prevailing rates.

A bond trades at a discount when its market price falls below par. For example, a $1,000 bond trading at $970 is discounted. An investor pays less than face value but receives full par value at maturity. Return includes coupon payments and capital appreciation from maturity.

Factors Driving Bond Discounts

Bonds trade at a discount due to changes in market interest rates or issuer credit quality. A common reason is a rise in prevailing market interest rates above the bond’s fixed coupon rate. When new bonds offer higher rates, existing bonds with lower coupons become less attractive. Their market price must fall to align yield with current market conditions.

For instance, if an existing bond pays a 3% coupon but new bonds offer 5%, its price decreases. This adjusts the bond’s effective yield, compensating new buyers for the lower coupon. The inverse relationship between bond prices and interest rates is fundamental: as rates rise, bond prices fall, and vice versa. This ensures a bond’s yield competes with current market offerings.

Deteriorating issuer credit quality is another factor. If an issuer’s financial health weakens or its credit rating is downgraded, investors perceive increased default risk. To compensate, investors demand a higher return, causing the bond’s price to fall below par. This discount offers a higher yield despite increased risk.

Time remaining until maturity also influences a bond’s discount. Longer maturity bonds are more sensitive to interest rate changes, so their prices fluctuate more. More time to maturity allows the bond’s price to converge back to par, making deeply discounted long-term bonds appealing for capital appreciation. Conversely, as a discount bond nears maturity, its value increases and slowly converges towards par.

Assessing the Value of Discounted Bonds

Determining if a discounted bond is a sound investment requires evaluating its Yield to Maturity (YTM). YTM estimates the total return an investor expects if holding the bond until maturity. It accounts for future coupon payments and capital gain from purchasing at a discount and receiving par value at maturity. This makes YTM a more complete measure than the coupon rate or current yield.

For a bond trading at a discount, its YTM will always be higher than its coupon rate. YTM incorporates the investor’s profit from the bond’s price appreciating to par value at maturity, plus coupon payments. The YTM calculation finds the discount rate that equates the present value of all future cash flows to the bond’s current market price. This allows standardized comparison of bonds with different characteristics.

It is important to differentiate YTM from current yield. Current yield is a simpler calculation, considering only annual coupon payments relative to the current market price. While it provides a snapshot of immediate income, it does not factor in capital gain or loss if held to maturity. For discounted bonds, current yield is higher than the coupon rate but lower than YTM, as it doesn’t capture the full benefit of receiving par value at maturity. YTM offers a more accurate representation of the actual return.

A higher YTM on a discounted bond suggests a competitive total return, appealing to investors seeking income and capital appreciation. Comparing its YTM to newly issued bonds with similar characteristics (credit rating, maturity, call features) helps determine attractiveness. If a discounted bond offers a significantly higher YTM than comparable alternatives, it may indicate a favorable investment. The decision to invest should consider not just YTM, but also the reasons behind the discount.

Key Investor Considerations

Before investing in discounted bonds, evaluate several factors. Tax implications are significant, particularly for bonds with an Original Issue Discount (OID). An OID bond is initially sold below par, with the difference considered OID. For tax purposes, investors must accrue and report a portion of this discount as ordinary income annually, even without cash payment until maturity.

This annual income accrual, known as “phantom income,” creates a tax liability without cash flow, requiring investors to have other funds for taxes. The IRS considers OID interest, reported on tax returns. Brokers provide Form 1099-OID detailing OID income, applicable whether the bond is held to maturity or sold earlier. The IRS provides guidance on OID taxation in IRS Publication 1212.

Another crucial factor is call features. A callable bond grants the issuer the option to redeem it before maturity, typically at par or a slight premium. If an investor buys a discounted callable bond and interest rates fall, the issuer might call it, paying par value and limiting capital gain. This early redemption disrupts income and reinvestment plans, as proceeds may be reinvested at lower rates. Investors should consider the bond’s “yield to call” if callable.

Liquidity is also important. Some discounted bonds, especially from smaller entities or with less common features, may trade infrequently, making quick buying or selling difficult without impacting price. Investors should assess trading volume and market depth to ensure they can exit if needed.

A thorough assessment of credit risk remains paramount, especially when a bond trades at a discount due to issuer financial health concerns. Review financial statements and credit ratings to gauge their ability to meet payments. A deep discount might signal higher default risk, requiring careful due diligence.