Deep-discount bonds

Deep-discount bond is a bond that is issued with a significant discount to the investor i.e. cash received on issuance of bond will be significantly lesser than the cash redemption at maturity. Reason for the low market value is the issuer’s unhealthy financial condition. As the issuer’s ability to repay the principal and interest amounts becomes doubtful, the risk of investor increases resulting in a drop in the market value of the bond. To attract the investors, such issuers offer relatively higher interest rates than those normally prevailing in the market.

In addition, deep-discount bonds also include bonds from entities which are financially stable but are not offering or offering relatively lower nominal interest rates. As the issuer of the bond is offering no interest or relatively low interest payments to the investors, it’s market value will be lower than its face value.

Let’s see an example of a deep-discount bond.

Example

On 1 January 20X1, ABC Company issued bonds having face value of $200,000 carrying interest rate of 6% per annum at a discount of 25%. Interest is payable in arrears. Commission of $4,000 was paid to the dealer who arranged this transaction. Term of the debentures is four years and will be redeemed at par on 31 December 20×4. Effective interest rate is 15.566% per annum.

How will this financial liability be accounted for by ABC Company?

Answer

On 1 January 20×1, financial liability will be recognized at its fair value minus transaction costs. As the company has issued the bonds at 25% discount, it has raised $150,000 by issuing the bonds, which is the fair value of bonds. Financial liability will initially be recognized at the following amount:

Financial liability = $150,000 – $4,000 = $146,000

For subsequent accounting, we’ll make the amortized cost table as follows.