A bond that is issued or trading at a lower price than its par value
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What is a Discount Bond?
A discount bond is a bond that is issued at a lower price than its par value or a bond that is trading in the secondary market at a price that is below the par value. It is similar to a zero-coupon bond, only that the latter does not pay interest until maturity. A bond is considered to trade at a discount when its coupon rate is lower than the prevailing interest rates.
How a Discount Bond Works
When an investor purchases a bond, he/she expects to be paid interest by the bond issuer. However, the value of the bond is likely to increase or decrease with changes in the market interest rates. If interest rates go up, it results in a decline in the value of the bond. The bond must, therefore, sell at a discount. Hence the name, discount bond. The discount takes into account the risk of the bond and the creditworthiness of the bond issuer.
A discount bond is offered at a lower price than the prevailing market rate. Buying the bond at a discount means that investors pay a price lower than the face value of the bond. However, it does not necessarily mean it offers better returns than other bonds.
Let take an example of a bond with a $1,000 face value. If the bond is offered at $970, it is considered to be offered at a discount. If the bond is offered at $1,030, it is considered to be offered at a premium. Bonds trade in the secondary market and their prices change with changes in market conditions. However, the par value will still be repaid to investors when the bond reaches maturity.
Why Bond Prices Fluctuate During Trading
When a new bond is issued, it comes with a stated coupon that shows the amount of interest bondholders will earn. For example, a bond with a par value of $1,000 and a coupon rate of 3% will pay annual interest of $30. If the prevailing interest rates drop to 2%, the bond value will rise, and the bond will trade at a premium. If interest rates rise to 4%, the value of the bond will drop, and the bond will trade at a discount.
With changing interest rates, bond prices must adjust so that their YTM equals or is almost equal to the YTM of new bond issues. This is because bond prices and YTMs move in opposite directions. If interest rates are higher than the bond’s coupon rate, bond prices must decrease below the par value (discount bond) so that the YTM moves closer to the interest rates. Similarly, if interest rates drop below the coupon rate, bond prices rise above the par value. During periods when interest rates are continually falling, bonds will trade at a premium so that the YTM moves closer to the falling interest rates. Similarly, rising interest rates will result in more bonds trading at a discount of par value.
Why a Bond Sells at a Discount
A bond may be issued at a discount for the following reasons:
1. Bond issuer’s risk of default
When bondholders perceive the issuer as being at a higher risk of defaulting on their obligations, they may only be willing to purchase the bonds at a discount.
2. Fluctuating interest rates
When interest rates rise above the coupon rate of the bond, the bond will trade at a discount. This allows them to earn a sufficient return on their investment.
3. Credit rating review
A bond rating agency may lower the credit rating of an issuer. The lower rating means increased risk, so the bond will trade at a discount to compensate investors for the additional risk.
Pros and Cons of Investing in Discount Bonds
Discount bonds come with a high probability of appreciating in value as long as the bond issuer does not default. If the investors hold their bonds until maturity, they will be paid an amount equal to the par value of the bond, even though they initially paid an amount that is less than the bond’s par value.
Discount bonds may come with a higher risk of default depending on the financial status of the issuer. A company may opt to issue bonds after exhausting all other means of raising capital. A bond rating agency may also lower the rating of the issuer if it is convinced that the probability of the company defaulting on its current obligations has increased.
Related Resources
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FAQs
A discount bond is a bond that is issued for less than its par—or face—value. Discount bonds may also be a bond currently trading for less than its face value in the secondary market. A bond is considered a deep-discount bond if it is sold at a significantly lower price than par value, usually at 20% or more.
Why do people buy discount bonds? ›
Discount bonds are bonds that pay regular coupon interest and currently trade at a price below their par value. Yield to Maturity on discount bonds are comparable to the broader market. Discount bonds can provide a more tax-efficient return in non-registered accounts when compared to bonds purchased at par or GICs.
What is the difference between a discount bond and a premium bond? ›
A Discount bond has a coupon that is below current market yields for a similar rated issue. A Premium bond has a coupon that is above current market yields for a similar rated issue.
Is a discount bond a zero-coupon bond? ›
A zero-coupon bond is a bond that pays no interest and trades at a discount to its face value. It is also called a pure discount bond or deep discount bond. U.S. Treasury bills are an example of a zero-coupon bond.
Is a discount bond a capital gain? ›
For bonds with very small discounts: If the discount is less than 0.25% of the bond's face value times the number of years to maturity, the discount is taxed as a capital gain in the year the bond matures.
Who benefits from a discount bond? ›
One of the primary benefits of discount bonds is the higher yield for investors. The investors purchase bonds at a lower price than the face value of the bond, yet repaid with the par value at the maturity. Some of such bonds are even sold at a 20% or more discount.
Why are discount bonds more risky? ›
Discount bonds can indicate the expectation of an issuer's default, falling dividends, or a reluctance of investors to buy the debt. Discount bonds with longer-term maturities have a higher risk of default. Deeper discounted bonds indicate a company is in financial distress and is at risk of default on its obligation.
What are the disadvantages of discount bonds? ›
Discount Bonds Disadvantages
Maturity problems: Discount bonds with longer maturities may have higher expectations or chances of default because of an uncomfortable place in the current market for buying or selling bonds.
Are discount bonds riskier than premium bonds? ›
Discount bonds can be riskier but the lower the price, the higher the potential for gains. Premium bonds can deliver higher returns with less risk, but they can be problematic if they become callable.
How does someone make money when they buy a bond? ›
In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..
Depending on the issuer, zero-coupon municipal bonds may generate tax-free imputed income, which means you won't have to pay tax until the bond matures -- usually many years in the future. Corporate zeros, on the other hand, usually will lead to some annual tax liability even if you don't receive any interest in cash.
Why are treasury bills called zero coupon bonds? ›
But not all bonds have coupon payments. Those that do not are referred to as zero-coupon bonds. These bonds are issued at a deep discount and repay the par value, at maturity. The difference between the purchase price and the par value represents the investor's return.
Are zero coupon treasuries taxed as capital gains? ›
Although not paid until maturity, income from zero-coupon STRIPS is taxable in the year in which it accrues. Increases in TIPS principal value as a result of inflation adjustments are taxed as capital gains in the year they occur, even though an investor does not collect these gains until TIPS are sold or mature.
Does a bond discount increase interest expense? ›
The amount of the bond discount is amortized to interest expense over the bond's life. As a bond's book value increases, the amount of interest expense increases. The effective interest method considers the impact of the bond purchase price rather than accounting only for its par value or face value.
Are discount bonds amortized? ›
Bonds Issued at a Discount
This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The discount will increase bond interest expense when we record the semiannual interest payment.
How do you avoid capital gains on a bond? ›
The only time I bonds may escape federal taxes is if the money is used to pay for higher education. Among the many criteria you must meet to take the tax exclusion, your income must be under certain limits and you must apply the money to a qualified institution the same year you redeem the bond.
Should you buy bonds at discount? ›
Discount bonds may be a better choice if you're hoping to produce capital gains in the long term when you receive the return of principal at maturity. Premium bonds generally offer higher coupon rates, which could provide a more stable income stream.
What are the disadvantages of Discount bonds? ›
Discount Bonds Disadvantages
Maturity problems: Discount bonds with longer maturities may have higher expectations or chances of default because of an uncomfortable place in the current market for buying or selling bonds.
Why would someone buy zero coupon bonds? ›
For example, you might pay $3,500 to purchase a 20-year zero coupon bond with a face value of $10,000. After 20 years, the issuer of the bond pays you $10,000. For this reason, zero coupon bonds are often purchased to meet a future expense such as college costs or an anticipated expenditure in retirement.
Why would anyone buy a bond at premium? ›
More income
If you're a serious, long-term investor whose primary consideration is income, premium bonds may be attractive to you because they can provide higher cash flows over the life of the bond.
