Deep Discount Bond
Also written Deep discount bonds
A zero-coupon bond of very long tenure, issued at a steep discount to its face value and redeemed at par. IDBI issued such bonds; the Kisan Vikas Patra is another example.
In plain language
A zero-coupon bond pays no interest along the way. It is sold for less than its face value and repaid at face value on maturity; the investor's return is the difference.
Now stretch the tenure. The longer the investor has to wait for the single payment at the end, the less that payment is worth today, and the lower the issue price has to be. A zero-coupon bond with a very long tenure therefore sells at a steep discount — and that is all a deep discount bond is.
The workbook names two Indian examples: IDBI issued such bonds "many years back", and the Kisan Vikas Patra is another.
For the issuer the appeal is cash flow: nothing to pay for many years, then one bullet repayment. For the investor the trade-off is the opposite — no income to live on in between, and a price that swings hard when interest rates move.
How it works
What makes it a zero (Chapter 3, section 3.3.1). Bonds that do not pay coupon in their entire term are zero-coupon bonds, or "zeroes". They are issued at a discount to face value and redeemed at par. The return is not periodic interest but the difference between issue price and redemption value. Repayment is in one shot as a bullet payment at maturity.
What makes it deep. ZCBs of very long tenure are issued at a steep discount to face value; such ZCBs are known as deep discount bonds.
Why issuers use them. No intermittent strain of periodic coupon payments during the life of the bond. Cash stays in the company and can be used in the business over a longer horizon.
Why the price is so sensitive. Three workbook statements combine:
| Workbook statement | Applied to a deep discount bond |
|---|---|
| Zeroes carry more interest rate risk than a coupon-paying bond of the same maturity, due to higher duration | No coupons to shorten the duration |
| Higher the time to maturity, higher the duration and the interest rate risk | Very long tenure |
| Lower the coupon rate, higher the duration | Coupon is zero |
No reinvestment of coupons. Chapter 12 notes that choosing a cumulative structure protects against reinvestment risk, but in a marketable security it may expose the bond to higher price volatility — the same trade a deep discount bond makes.
The formula
The value of a bond is the discounted value of its future cash flows (Chapter 3). A zero has only one:
Price = Face value ÷ (1 + y)^n
y = market yield per period
n = periods to maturity
A worked example
Illustrative figures. Two zero-coupon bonds, each with face value Rs 1,00,000, priced at a market yield of 9%.
10-year zero: 1,00,000 ÷ 1.09^10 = Rs 42,241
20-year zero: 1,00,000 ÷ 1.09^20 = Rs 17,843
The 20-year bond is the deep discount bond: the investor pays about 18% of face value and waits twenty years for the rest. The issuer pays nothing for two decades, then Rs 1,00,000 in one bullet.
Now let the market yield rise to 10%.
10-year zero: 1,00,000 ÷ 1.10^10 = Rs 38,554 → change −8.7%
20-year zero: 1,00,000 ÷ 1.10^20 = Rs 14,864 → change −16.7%
The same one-percentage-point move costs the deep discount bond almost twice the percentage loss of the 10-year zero. That is the workbook's rule in rupees: longer maturity and no coupon mean higher duration and higher interest rate risk.
For an investor who holds to maturity, the interim price is irrelevant — she paid Rs 17,843 and receives Rs 1,00,000. For one who might need to sell in year 5, the price at that point depends heavily on where rates are, which is the risk she took on.
Why NISM asks about it
Chapter 3 (Terminology in Equity and Debt Markets) introduces deep discount bonds inside section 3.3.1 on zero-coupon bonds, next to T-Bills, CPs and CDs as short-term zeroes and the ETHL Communications zero-coupon issue of October 2009. Duration and interest rate risk are taught in the same chapter.
Expect a question on what distinguishes a deep discount bond from other zeroes (very long tenure, steep discount), the named examples (IDBI, Kisan Vikas Patra), and why zeroes carry more interest rate risk than coupon bonds of the same maturity.
Common exam traps
- A deep discount bond is a zero-coupon bond. It does not pay a small coupon; it pays none.
- Long tenure is what makes the discount deep. T-Bills, CPs and CDs are also zeroes, but short-term — money market instruments of less than 1 year, not deep discount bonds.
- Redeemed at par, not at a premium, in the workbook's description of zeroes.
- More interest rate risk, not less, than a coupon-paying bond of the same maturity.
- No coupon means no reinvestment of coupons — but it does not mean no risk; price volatility is higher.
- The rupee return may look the same as a coupon bond's; the workbook's point is that the risk is not.
- The workbook calls the Kisan Vikas Patra a deep discount bond example. It gives no KVP maturity or doubling period in this chapter — do not import one from memory.
Check yourself
1.Zero coupon bonds are:
- a)Issued at par and redeemed at a premium
- b)Issued at a discount to face value and redeemed at par
- c)Issued at a premium and redeemed at par
- d)Issued and redeemed at face value, with interest paid annually
Show the answer
Answer: (b) Issued at a discount to face value and redeemed at par
Bonds which do not pay coupon in their entire term are known as Zero Coupon Bonds or simply "Zeroes". Such bonds are issued at a discount to their face values and are redeemed at par. Thus, the return on these bonds is not in the form of periodic payment of interest but in the form of difference between the issue price and redemption value.
Their risk: while in rupee terms the returns may be same for an investor, inherently, Zeroes carry more interest rate risk due to their higher duration than a coupon paying bond of the same maturity.
Why issuers like them: such bonds are used by issuers to manage their cash flows as there is no intermittent strain during the life of the bond to make periodic coupon payments. Cash remains within the company and can be used in the business with a slightly longer-term horizon. Repayment of the loan would be in one shot as a bullet payment at the maturity.
Common examples: Treasury Bills issued by Government of India, Commercial Papers issued by corporates and Certificate of Deposits issued by banks and financial institutions are examples of short-term zero-coupon bonds. These are also known as Money Market instruments, the money market being that segment of Debt market in which securities of less than 1 year are issued and traded.
And the long-tenure version: ZCBs of very long tenure are issued at a steep discount to their face values. Such ZCBs are also known as Deep Discount Bonds — with the Kisan Vikas Patra as an example.
Where this is taught
Free preparation for NISM Series IVRelated terms
- Interest rate riskThe risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
- Modified DurationMacaulay's duration divided by (1 + yield) — the percentage by which a bond's price moves for a one percentage point change in interest rates, and so the standard measure of interest rate risk.
- Reinvestment riskThe risk that the coupons or other intermediate cash flows from an investment have to be put back to work at a lower rate than the original investment earned, pulling the total return below the promised yield.
- Zero coupon bondA bond that pays no coupons: it is issued below face value and repays the face value at maturity, so its duration equals its maturity.
- Kisan Vikas PatraA government-guaranteed post office certificate that doubles the amount invested over a fixed term — 124 months in the workbook — with no tax incentive and interest taxed on accrual.
- Money Market InstrumentsDebt instruments with maturity of one year or less. Under the PM Regulations they include commercial paper, trade bills, treasury bills, certificates of deposit and usance bills.
- Inverse floaterA bond whose coupon moves opposite to its reference benchmark — it pays more as market rates fall and less as they rise, the reverse of an ordinary floating-rate bond.
- Domestic bondA bond issued by an authorised entity of a country, in the bond market of its own home country, and denominated in its own home currency.
- Euro bondAn external bond issued in a foreign country in a currency that is not the local currency of that country — nothing to do with Europe or with the euro.
- Discount bondA bond whose market price sits below its par value because the prevailing market interest rate is higher than its coupon — a market-price condition of an ordinary bond, not a distinct bond type.