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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

3 Surprising Reasons Why Discounted Bonds May Be A Bad Idea...

My old accounting professor clued me into a lesson about sales.

If a retailer offers a sale on a product on a regular basis, that's the real price. When you don't buy the same item on sale, you're paying an inflated price.

With bonds, however, it gets a little more complicated. When I buy a shirt, I know how it's going to look on me and what pants I'll pair it with. I'll also probably wear it within a couple of weeks of the purchase date.

But buying discounted bonds isn't like buying that shirt:  It can be a very long time before you are able to fully benefit. After all, they may not reach maturity -- the day they can be cashed out at full value -- for 10 or 15 years. 

And that's just one reason to think twice about buying those kinds of bonds. There are other very good reasons to reconsider purchasing them. Here are three:

1. That Discount May Not Be Much Of A Bargain

Let's say you buy a bond with a $1,000 face value for $500 and the bond reaches maturity on September 30, 2023. In other words, it will take 10 years before you're guaranteed the $1,000. In the meantime, you don't have your $500.

The usual reason for a bond to be sold at a discount is the fixed interest rate is lower than what's being offered in the current market. The number of percentage points of difference varies widely. Think about your mortgage. You could score a 3% rate now while five years ago 7% was considered a good deal.  

Compare the interest rate you're currently earning on other investments. For instance, if you're averaging a 5 percent annual rate of return on $500, you'd have more than $800 by the end of 10 years.

So if you got a 50 percent deal on the bond, it would be worth it. If you bought a $1,000 bond for $750, the bond may not be worth investing in.

2. If The Company Goes Away, So Does Your Money

If you're buying a bond -- discounted or not -- be sure to think about the stability of the company whose bond you're buying. If you're purchasing a federal government bond, this isn't an issue. (After all, if the federal government went bankrupt, we'd all have bigger worries than one bond's stability.)

But if you buy a corporate bond, you have to count on the company being around when your bond hits maturity. If the company goes belly up before your bond hits maturity, more than likely your bond will, too.

If your bond matures in 10 to 15 years, that's a big prediction to make. It's a slightly easier decision if you bought the bond with less than five years until maturity.

3. Interest Rates Aren't The Only Reasons Bonds Are Discounted

Sometimes the discount is due to the perceived risk of the company. A company that's issuing bonds that isn't in the best financial state could issue bonds at a discount in order to get the money it needs, says Michael Eisenberg, CPA and personal financial specialist.

A bond is simply a loan product for a specific number of years at a specific interest rate. It may be that if you're going to take the risk of buying a bond from a company that's shaky financially, you might be better off buying stock where if the company succeeds you could gain more profit, more quickly.

The Investing Answer: Talk to a certified financial planner or CPA before buying any discounted bonds and discuss all the pros and cons.

Discounted corporate bonds are way too risky to invest in without help from a financial professional. And a financial professional can also help you weigh the value of government bonds versus other investments over the time period until maturity.

And there are plenty of other options out there. For example, check out our search tool below that will help you find the nation's highest CD yields.