Deeply Discounted Security

A loan stock or government security issued on terms that make the redemption value significantly higher than the issue price, often with more than 15% discrepancy or ½% per completed year.
On this page

What is a Deeply Discounted Security?

A deeply discounted security refers to a loan stock or government security issued under conditions where the amount paid out upon maturity or any other form of redemption substantially exceeds the issue price. The key thresholds that characterize a deeply discounted security are:

  • The redemption amount exceeds the issue price by more than 15%, or
  • It exceeds the issue price by more than 0.5% for each completed year between the issue date and the redemption date.

Examples

  1. Deep Discount Bond - Short Term Example:

    • A four-year loan stock issued at £95 for every £100 nominal value. Since the discount exceeds 0.5% per annum (equating to a 2% difference over four years), it is classified as a deeply discounted security.

  2. Deep Discount Bond - Long Term Example:

    • A 25-year loan stock issued at £75 for every £100 nominal value. Here, the discount exceeds 15% in total, further classifying it as a deeply discounted security.

Treatment and Tax Implications

The discount on deeply discounted securities is typically treated as income that accrues over the life of the security. This accrued income is subject to income tax upon the sale or redemption of the security. Therefore, investors in such securities should account for the potential tax liabilities associated with the discount over time.

Frequently Asked Questions (FAQs)

1. What is the primary benefit of investing in deeply discounted securities?

  • The primary benefit is the potential for a higher yield upon redemption compared to the initial investment. This can be advantageous in portfolios seeking long-term appreciation.

2. How is the discount on deeply discounted securities taxed?

  • The discount is treated as income accruing over the life of the security and is charged to income tax on sale or redemption.

3. Are there risks associated with deeply discounted securities?

  • Yes, these include interest rate risk, credit risk, and potential tax implications due to the income accrual nature of the discount.

4. Can deeply discounted securities be held in tax-advantaged accounts?

  • This depends on the jurisdiction and specific tax laws. Some tax-advantaged accounts may allow holding such securities without immediate tax implications.

5. Why would a company or government issue deeply discounted securities?

  • Issuing deeply discounted securities can make borrowing more attractive by providing higher yields to investors, especially in environments with lower prevailing interest rates.
  • Zero-Coupon Bond: A bond issued at a deep discount to its face value that does not pay periodic interest payments. The investor profits by the bond appreciating to face value by maturity.
  • Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures. Includes all coupon payments and the difference between current market price and maturity value.
  • Amortized Cost: The adjusted value of a security after accounting for interest income received and principal repayment over time.

Online References

Suggested Books for Further Studies

  • Fixed Income Analysis by Barbara S. Petitt
  • Bond Markets, Analysis, and Strategies by Frank J. Fabozzi
  • Principles of Corporate Finance by Richard A. Brealey and Stewart C. Myers
  • The Bond Book by Annette Thau

Accounting Basics: “Deeply Discounted Security” Fundamentals Quiz

Loading quiz…

Thank you for diving deep into the details of deeply discounted securities. This thorough understanding and the challenging quiz will help reinforce fundamental concepts and ensure you stay sharp in your financial expertise!

Defalcation
Deep Pockets