The fixed deposit represented the quintessential example of the Indian investor’s behavior. It meets all the requirements that an average Indian seeks – safety, predictable returns and the assurance of receiving their money back on time. However, in the early 1990s, deep discount bonds emerged as a challenge to the established order. Investors were attracted to the opportunities offered by institutions such as IDBI and ICICI. What were the reasons behind this shift from the traditional fixed deposit investment mindset?
Deep discount bonds are a unique type of bond that pays minimal or no periodic interest payments. Instead, they are issued at a steep discount to their face value and redeemed at maturity for their full face value. These bonds are typically issued by government entities, banks or corporations and can be an attractive investment for investors seeking long-term capital gains. In this article, we will explore the meaning of deep discount bonds, provide an example and calculation of these bonds, discuss their features and differentiate them from zero coupon bonds.
Deep discount bonds meaning bonds issued at a significant discount to their face value, usually 20% or more. The discount represents the interest that would have been paid if the bond had been issued at par. Instead, the bond pays low or no periodic interest payments and the entire interest is included in the final redemption value.
Issuing deep discount bonds at a discount is one of the ways in which issuers can avoid the burden of coupon payments. By issuing bonds at a discount, the total interest paid over the bond’s life can be reduced by the issuer. Additionally, a company may issue bonds at a discount if its financing project does not generate a predictable stream of cash flows. By issuing bonds at a discount, the company can reduce the overall financing costs while also attracting investors.
IDBI Deep Discount Bonds: In 1992, the Industrial Development Bank of India (IDBI) pioneered deep discount bonds. The bonds were offered at Rs. 2,700 for a face value of Rs. 1 lakh and had a maturity period of 25 years. Investors were to receive a face value of Rs. 1 lakh after 25 years and the bonds offered a yield of 15%.
ICICI Bank’s Ashirwad Deep Discount Bond: These bonds were issued in 1996 with a maturity period of 25 years. The bonds were initially issued at a face value of Rs. 2,00,000, but they were sold at a discounted price of Rs. 5200. However, upon maturity, they were redeemed at their full face value of Rs. 2,00,000.
NABARD Deep Discount (Bhavishya Nirman Bonds): These bonds are also referred to as Nabard bonds. They were issued in 2007 at Rs. 9,250 for investments above 5 crore and at Rs. 9,300 for investments below 5 crore, with a maturity value of Rs. 20,000 after 10 years. The YTM was 8.01% and 7.95%, respectively.
Let us take an example of a deep discount bond to understand how they work. H.D. Corp issues a bond with a face value of Rs.10,000 and a maturity of 20 years. The bond has an annual coupon rate of 5%, but it is issued at a discount of 60%. This means that the investor will pay only Rs.4,000 for the bond.
The calculation of the bond’s price is as follows:
Bond price = (Coupon payment x Present value factor) + (Face value x Present value factor)
Coupon payment = 5% x Rs.10,000 = Rs.500
Present value factor = 1 / (1 + r)^n, where r is the discount rate and n is the number of periods
Assuming a discount rate of 10%, the present value factor for 20 years is 0.1486. Hence, the value of the bond can be determined using the following calculation:
Bond price = (Rs.500 x 0.1486) + (Rs.10,000 x 0.1486) = Rs.1,486 + Rs.1,486 = Rs.2,972
Thus, the investor pays Rs.2,972 for the bond and will receive Rs.10,000 at maturity, resulting in a capital gain of Rs.7,028.
Some of the features of deep discount bonds are as follows:
a. Low or no periodic interest payments: Generally deep discount bonds have low or no periodic interest payments. Instead, the interest is included in the final redemption value.
b. High capital gains potential: Since the bonds are issued at a significant discount, there is potential for high capital gains at maturity.
c. Long-term investment: Deep discount bonds typically have a long maturity, ranging from 10 to 30 years, making them suitable for long-term investment.
Zero coupon bonds are issued at a discount to their face value and do not pay any periodic interest payments. The entire interest is included in the final redemption value. Deep discount bonds are also issued at a discount to their face value, but they may have a coupon rate, which is included in the final redemption value.
Another key difference is that zero coupon bonds have a fixed maturity date, while deep discount bonds may have a range of maturity dates.
Additional difference is in the taxation of the two types of bonds. Since zero coupon bonds do not pay any periodic interest payments, investors are not required to pay any taxes on the interest income. However, deep discount bonds may have a coupon rate and investors are required to pay taxes on the interest income.
Overall, both deep discount bonds and zero coupon bonds offer investors the potential for high capital gains at maturity, but they differ in terms of their maturity dates, coupon rates, issuer types and tax implications.
Deep-discount bonds are generally issued with a longer maturity period, often ten years or more and include call provisions. These call provisions embedded in the contract permit the bond-issuing entity to repurchase the bond during its holding period and retire the debt security before its maturity. By the year 2000, when the market interest rate dropped, most of the bonds mentioned in the above example were called back for early redemption by the issuers. Therefore, investors must do their due diligence and read the information memorandum and term sheet before investing.
In conclusion, deep discount bonds are a distinctive form of bond issued at a significant discount to their face value, often by government entities and corporations, with a high potential for long-term capital gains. These bonds are particularly appealing to Indian investors, as they are considered ‘quasi-FDs’ and provide better returns than fixed deposits. Although similar to zero coupon bonds, deep discount bonds differ in their coupon rates, maturity dates, issuer types and tax implications. Investors interested in deep discount bonds should carefully evaluate the creditworthiness of the issuer, the prevailing interest rate environment and their investment objectives before making any investment decisions.
A: The advantage of investing in a deep discount bond is that it provides the investor with a higher yield or return on investment compared to traditional bonds.
A: A call provision is an embedded feature in a deep discount bond that allows the bond issuer to repurchase the bond before its maturity date.
A: Issuers of deep discount bonds may call back their bonds for early redemption when market interest rates drop, allowing them to refinance at a lower rate.
A: Investors should consider the creditworthiness of the issuer, the interest rate risk, the call risk and the liquidity risk before investing in deep discount bonds.
A: Deep discount bonds are generally suitable for investors who have a longer investment horizon and are willing to assume higher risks to earn higher returns.
Disclaimer: Investments in debt securities are subject to risks. Read all the offer related documents carefully.
