A deep discount bond is a bond that is sold at a price significantly lower than its par value, usually 20% or more. Deep discount bonds are often issued by companies with weak credit ratings, as they are a way to attract investors who are willing to take on more risk in exchange for a higher potential return.

Deep discount bonds typically offer low or no coupon payments, which means that the investor earns their return through the difference between the purchase price and the par value at maturity. For example, if you purchase a deep discount bond with a par value of ₹100 for ₹50, you will earn a 50% return if you hold the bond to maturity.

Deep discount bonds are considered to be high-risk investments, as the issuer may not be able to repay the bond at maturity. However, they can also be very rewarding investments, especially if the issuer is able to improve their credit rating over time.

Here are some of the advantages and disadvantages of investing in deep discount bonds:

Advantages:

• Higher potential returns than traditional bonds
• May provide capital gains if the issuer’s credit rating improves

Disadvantages:

• Higher risk of default
• Low or no coupon payments
• More volatile than traditional bonds

Deep discount bonds can be a good investment for investors who are willing to take on more risk in exchange for a higher potential return. However, it is important to carefully consider the risks involved before investing in deep discount bonds.

Here are some examples of deep discount bonds:

• Zero-coupon bonds
• Treasury Inflation-Protected Securities (TIPS)
• Floating-rate notes (FRNs)
• Callable bonds
• Convertible bonds

Example

An example of a deep discount bond is a zero-coupon bond. Zero-coupon bonds are issued at a discount to their face value and do not pay interest coupons. Instead, investors receive the full face value of the bond at maturity. Zero-coupon bonds are often issued by governments and corporations with high credit ratings.

Another example of a deep discount bond is a bond that has been downgraded by a credit rating agency. Investors may be willing to buy these bonds at a discount because they are riskier than other bonds.

Here is a specific example of a deep discount bond:

• A company issues a zero-coupon bond with a face value of ₹10,000 and a maturity date of 5 years.
• The bond is issued at a discount of 20%, meaning that investors can buy it for ₹8,000.
• At maturity, investors will receive the full face value of the bond, ₹10,000.

In this example, the bond is a deep discount bond because it is issued at a discount of 20% to its face value. Investors are willing to buy the bond at a discount because they will receive the full face value of the bond at maturity, even though it does not pay any interest coupons.

Case laws

Madras Industrial Investment Corporation Ltd. v. CIT (1995) 225 ITR 802:

In this case, the Supreme Court held that the discount on deep discount bonds is a deductible expenditure for the issuer. The Court also held that the difference between the issue price and the redemption price of deep discount bonds is taxable as interest income in the hands of the investor.

CIT v. UTI Trustee Company (2005) 282 ITR 358:

In this case, the Delhi High Court held that the discount on deep discount bonds is a capital expenditure for the issuer. The Court also held that the difference between the issue price and the redemption price of deep discount bonds is taxable as capital gains in the hands of the investor, if the bond is held till maturity.

CIT v. Kotak Mahindra Bank (2012) 347 ITR 64:

In this case, the Bombay High Court held that the discount on deep discount bonds is a revenue expenditure for the issuer. The Court also held that the difference between the issue price and the redemption price of deep discount bonds is taxable as interest income in the hands of the investor, irrespective of whether the bond is held till maturity.

CIT v. Reliance Capital Ltd. (2019) 411 ITR 243:

In this case, the Supreme Court upheld the judgment of the Bombay High Court in Kotak Mahindra Bank case. The Supreme Court held that the discount on deep discount bonds is revenue expenditure for the issuer and the difference between the issue price and the redemption price of deep discount bonds is taxable as interest income in the hands of the investor, irrespective of whether the bond is held till maturity.

The current tax treatment of deep discount bonds in India is as follows:

• The discount on deep discount bonds is a deductible expenditure for the issuer.
• The difference between the issue price and the redemption price of deep discount bonds is taxable as interest income in the hands of the investor, irrespective of whether the bond is held till maturity.

Faq question

Q: What are deep discount bonds?

A: Deep discount bonds are bonds that are sold at a significant discount to their face value. This means that the investor pays less for the bond than they will receive when it matures. Deep discount bonds are typically issued by companies that are in financial difficulty or that are issuing bonds to finance new projects.

Q: Why are deep discount bonds issued?

A: Companies issue deep discount bonds for a number of reasons. One reason is that they may be in financial difficulty and need to raise money quickly. Another reason is that they may be issuing bonds to finance new projects and are willing to offer a discount to investors in order to make the bonds more attractive.

Q: What are the risks of investing in deep discount bonds?

A: There are a number of risks associated with investing in deep discount bonds. One risk is that the issuer may default on the bond and the investor will not receive the full face value of the bond when it matures. Another risk is that the bond may be callable, which means that the issuer can redeem the bond before maturity. If the bond is callable, the investor may have to sell the bond at a loss.

Q: How are deep discount bonds taxed?

A: Deep discount bonds are taxed as ordinary income when they are redeemed. This means that the investor must pay tax on the difference between the price they paid for the bond and the face value of the bond.

Q: What are the advantages of investing in deep discount bonds?

A: The main advantage of investing in deep discount bonds is that they offer the potential for high returns. If the investor holds the bond until maturity and the issuer does not default, the investor will receive the full face value of the bond. This means that the investor can potentially earn a very high return on their investment.

Q: What are the disadvantages of investing in deep discount bonds?

A: The main disadvantage of investing in deep discount bonds is that they are riskier than other types of bonds. This is because there is a greater risk that the issuer will default on the bond or that the bond will be called before maturity.

Q: Who should invest in deep discount bonds?

A: Deep discount bonds are suitable for investors who are willing to take on more risk in order to potentially earn higher returns. Deep discount bonds are also suitable for investors who have a long-term investment horizon and are comfortable holding the bond until maturity.