Deeply Discounted Security

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

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.
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

### What defines a deeply discounted security? - [x] A loan stock issued at a significant discount to its nominal value. - [ ] A stock that pays high dividends. - [ ] A bond with no interest payments. - [ ] A government security that is tax-free. > **Explanation:** A deeply discounted security is defined by its issuance at a price significantly lower than its nominal value, where the amount payable at maturity exceeds the issue price substantially. ### Over how much should the total discount exceed in deep discount bonds to be classified as deeply discounted? - [ ] 10% - [x] 15% - [ ] 5% - [ ] 20% > **Explanation:** The total discount should exceed 15% in order to classify as a deeply discounted security. ### How is the discount on deeply discounted securities treated for tax purposes? - [ ] It is considered as capital gain. - [x] It is treated as income accruing over the life of the security. - [ ] It is tax-free. - [ ] It is added to the principal amount. > **Explanation:** The discount is generally treated as income accruing over the life of the security and is subject to income tax. ### Why might an issuer offer deeply discounted securities? - [x] To attract investments by providing higher yields. - [ ] To reduce their debt obligations. - [ ] To avoid paying dividends. - [ ] To circumvent tax regulations. > **Explanation:** Issuing deeply discounted securities can make borrowing more attractive by offering higher yields, especially in a low-interest-rate environment. ### What is the effect of deeply discounted securities on an investor's portfolio? - [ ] Decrease the portfolio's risk. - [ ] Increase immediate cash flow. - [x] Potentially high long-term appreciation. - [ ] Guaranteed income without tax implications. > **Explanation:** Deeply discounted securities can potentially offer high long-term appreciation due to the significant difference between their purchase price and redemption value. ### Can deeply discounted securities offer any periodic payments? - [ ] Yes, regularly. - [x] No, they usually do not offer periodic payments. - [ ] Yes, but infrequently. - [ ] Yes, depending on interest rates. > **Explanation:** Typically, deeply discounted securities do not offer periodic payments; they are structured to provide a lump-sum return at maturity. ### What is a zero-coupon bond in relation to deeply discounted securities? - [x] It is a bond issued at a deep discount, without periodic interest payments. - [ ] A bond with variable interest rates. - [ ] A stock without dividends. - [ ] A short-term government security. > **Explanation:** A zero-coupon bond is issued at a deep discount and does not provide periodic interest payments, aligning with the characteristics of deeply discounted securities. ### How does the redemption value relate to the issue price in a deeply discounted security? - [x] Redemption value is significantly higher than the issue price. - [ ] Redemption value is equal to the issue price. - [ ] Redemption value is less than the issue price. - [ ] There is no correlation. > **Explanation:** For a security to be deeply discounted, the redemption value must substantially exceed the issue price, often beyond the 15% threshold. ### What type of account should an investor consider to manage the tax implications of deep-discount securities? - [ ] A brokerage account - [x] A tax-advantaged account - [ ] A savings account - [ ] A traditional checking account > **Explanation:** An investor may consider a tax-advantaged account, which can help manage or defer the tax implications associated with the income accrual of deeply discounted securities. ### What is the investment strategy commonly associated with deeply discounted securities? - [x] Long-term holding to maturity. - [ ] Short-term trading. - [ ] Day trading. - [ ] Using derivatives for leverage. > **Explanation:** Investors often employ a long-term strategy to hold deeply discounted securities until maturity to realize the significant return on their investment.

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!