Question

An investor is looking through various bond alternatives for potential investment. She has noticed a large number of them are currently selling for less than their original par value and is confused and nervous as to what this may mean for her potential investment if she purchases one of these. Please describe how and why these type of situations occur.

Answer 1

A discount bond is a bond that is issued at a lower price than its fair value or Par value.It is similar to a zero coupon bond, only that the latter does not pay interest until maturity.A bond is considered to trade at a discount when its Coupon rate is lower than the prevailing interest rates.

A bond may be issued at a discount for the following reasons;

1.Bond issuer's risk of default:When bondholders perceive the issuer as being at a higher risk of defaulting on their obligations, they may only be willing to purchase the bonds at discount.

2.Fluctuating Interest rats:When interest rates rises above the coupon rate of the bond, the bond will trade at discount.This allows them to earn a sufficient return on their investment.

3.Credit rating review:A bond rating agency may lower the credit rating of an issuer.The lower rating means increased risk,so the bond will trade at a discount to compensate investors for the additional risk.

Pros and Cons of Investing in Discount Bonds

Discount bond comes with a high probability of appreciating in value as long as the bond issuer does not default.If the investors hold their bonds until maturity,they will paid an amount equal to the par value of the bond,even though they initially paid an amount that is less than the bond's par value.

Discount bond may comes with higher risk of default depending on the fianancial status of the issuer.A company may opt to issue bonds after exhausting all other means of raising capital.A bond rating agency may also lower the rating of the issuer it is conviced that the probability of the comapny defaulting on its current obligation has increased.