Deep Discount Bonds Explained: Meaning, Types, Benefits, and Taxation

Imagine your favourite watch company launches a new classic watch and also gives you a special pre-booking offer to get a Rs.80,000 watch for just Rs.20,000 but there is one condition you will receive this watch in five years. You get the same high-value watch for a fraction of the price, the only thing is you wait. This is the concept we witness in Deep Discount Bonds. 

Deep Discount Bonds are simple, investors buy it for a low price today and get a much higher, fixed amount back in the future. Your profit is the difference between the low price you pay while buying and the high price you get back at maturity, this is because these bonds usually don’t pay regular interest while you hold them. 

How Deep Discount Bonds Work?

To understand how these bonds work, let’s look at a real example from the 1990s in India. In the year 1992, IDBI bank offered a bond where investors can just invest Rs.2,700 and in return can earn Rs.1 Lakh in return but after 25 years. In 1996, ICICI Bank launched a Deep Discount Bond named “Ashirwad Bond” where you can just invest Rs.5,200 and get Rs.2 Lakhs in return. Here we witness the idea of Deep Discount Bonds where you invest a small amount today and let it grow into a large sum over many years.   

Characteristics of Deep Discount Bonds

• Discounted Prices: Here the discount is your profit, where you buy the bond for much less than its final face value, this is the most important feature. 
• No or very low Coupon Payments: Investors generally don’t get monthly or yearly interest , the real return is earned in one large payment at the maturity.   
• Locked in Investment: The maturity period of these bonds is generally 10, 15, or even 25 years. These are best suitable for investors looking for long-term returns and who do not have a liquidity constraint during the holding period.

Read Also: Detailed Guide on Bond Investing

Types of Deep Discount Bonds

1. Zero-Coupon Bonds

These bonds are designed in such a way that they don’t give regular interest payments, Zero-Coupon Bonds are the most common type of bonds issued. In these bonds the whole return comes from the difference between the low issued price and high returns at maturity. IDBI Bank and ICICI Bank had issued bonds that were zero-coupon in nature in the 1990s.

2. Low-Coupon Bonds 

These bonds pay a few regular interest, but the interest rate is minimal.To make them lucrative for the investors, the companies sell them at a deep discount, the investors earn small regular income but the reward is earned at the maturity by getting all your money at once.   

3. Distressed Bonds 

Sometimes, a normal bond becomes a deep discount bond. This happens when investors worry about the company’s financial health or due to some market rumours. If everyone starts to get skeptical and think that the company might not repay its loans, they start to rapidly sell their bonds. This panic selling results in falling stock prices, creating a deep discount. These types of bonds are known as “junk bonds” which are often very risky in nature.   

Advantages and Disadvantages of Deep Discount Bonds

Advantages

• Potential for High Returns: As the money is invested for a long time, it can grow significantly. A small investment can give you a large result, making it suitable for your long-term goals.   
• Lower Initial Investment: As they are sold at such big discounts, you need less money while buying them initially as compared to regular bonds in the market. This makes an easy entrance and accessible to more people with low capital.   
• Predictable Payout: If the investors have trust in the issuer, you can easily predict your large amount of money at maturity. This helps in easy future planning.   

Disadvantages:

• Credit Risk: The companies might fail to pay back the invested amount, this is the biggest risk.It’s important to choose bonds from companies with high credit or issue ratings—AAA is considered the safest.
• No Regular Income: These bonds don’t provide cash flow till the time they get mature. They are not suitable for people who need a regular interest income.   
• Interest Rate Risk: Bond prices and interest rates move in opposite directions. If interest rates go up after you buy a bond, its market value will go down. If you need to sell it before maturity, you might have to sell at a loss.   

Read Also: What are Bond Valuation?

Taxation

As the bonds do not pay interest, your profit is taxed as ‘Capital Gains’ on the whole investment, not on ‘Interest Income’ and the tax depends on how long you hold the bond.   

• Short-Term Capital Gain (STCG): If you sell a listed bond in less than 12 months, your profit is a short-term gain. This profit is added to your total income and taxed as per your income tax slab rate.   
• Long-Term Capital Gain (LTCG): If you hold a listed bond for more than 12 months, your profits are taxed in long-term gain. This is taxed at a flat rate of 12.5% (plus cess). 

Read Also: Benefits of Investing in Bonds

Conclusion

Deep Discount Bonds offer a unique way to build wealth over time. They let you invest a small amount of money in return for a potentially large future payout. However, they are best suitable for patient investors who have long term goals and are willing to lock their money for many years. Also as we have seen there are no regular interest payments.  Understand the risks, especially credit risk, and check the issuing company’s rating. Ultimately, making smart investments is about gaining knowledge. 

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