Deeply Discounted Security: Understanding Discounted Investments

A Deeply Discounted Security is a type of loan stock or government security that is issued at a significant discount compared to its nominal value. The amount payable on maturity or redemption significantly exceeds the issue price, typically by more than 15%, or by more than ½% per annum for each completed year between issue and redemption.

Types

• Government Deeply Discounted Bonds: Issued by national governments, these are generally considered low-risk.
• Corporate Deeply Discounted Bonds: Issued by corporations, these might carry higher risk but potentially higher returns.
• Zero-Coupon Bonds: These bonds do not pay periodic interest but are issued at a deep discount, providing profit at maturity.

Example Calculation

A four-year deeply discounted bond issued at £95 with a nominal value of £100:

The discount: \( £100 - £95 = £5 \)

The annual discount rate: \( \frac{5}{95} \times 100 \approx 5.26% \) per annum

A 25-year bond issued at £75 with a nominal value of £100:

The discount: \( £100 - £75 = £25 \)

The total discount rate: \( \frac{25}{75} \times 100 \approx 33.33% \)

Tax Implications

The discount is typically treated as income accruing over the life of the bond and is taxed as such upon sale or redemption.

Mathematical Formulas/Models

• Present Value Formula for Zero-Coupon Bonds:
  $$ P = \frac{F}{(1 + r)^n} $$
  where:
  • \( P \) = Present value (issue price)
  • \( F \) = Face value (nominal value)
  • \( r \) = Discount rate
  • \( n \) = Number of periods

Importance

• For Investors: Provides an opportunity for capital appreciation and regular income.
• For Issuers: A means to raise capital without immediate cash flow obligations.

Related Terms

• Coupon Rate: The interest rate paid by bond issuers to bondholders.
• Yield to Maturity (YTM): The total return expected on a bond if held until maturity.

FAQs

Q1: How are deeply discounted securities taxed?
A1: The discount is typically treated as income accruing over the life of the bond and is taxed upon sale or redemption.

Q2: What are the risks associated with deeply discounted securities?
A2: Risks include interest rate fluctuations, credit risks of the issuer, and potential tax liabilities.