What it means
The word only makes sense once you know what the reference point is, so the first question is always "a discount to what?". For a bond it is the face value repayable at maturity, for an investment trust it is the net asset value per share, and for a new share issue it is the current market price.
Each comparison carries a different meaning. Bonds trade at a discount mainly when their fixed coupon is below what the market now demands.
If a bond pays 5% and comparable new issues pay 7%, nobody will pay full face value for the older bond, so its price falls until the total return matches. The discount is therefore a price adjustment, not a bargain.
Closed-end funds and investment trusts often trade at a discount to the value of the assets they hold, sometimes 5% to 20%. The reasons include limited liquidity, doubts about management, high fees or simply weak demand for the shares.
Buyers hope the discount narrows over time, which would add to their return alongside any growth in the underlying assets. Discounts appear in ordinary commercial life too, and the accounting differs from the finance meaning.
A rights issue may be priced at a discount to the market price to encourage take-up, and a supplier may offer a settlement discount for early payment. In each case the discount is a deliberate incentive rather than a market judgement.
The opposite condition is trading at a premium, where the price exceeds the reference value. Watching a security move between discount and premium over time is a useful signal about sentiment, because the underlying assets may not have changed at all.
That gap between price and value is where a great deal of investment analysis lives.
In practice
Real-world examples.
Example
An investment trust holding property assets worth $250,000,000 has a market capitalisation of $215,000,000, so its shares trade at a 14% discount to net asset value. Investors debate whether the gap reflects genuine doubt about the property valuations or simply thin trading in the shares.
Example
A company raises capital through a rights issue priced at $4.20 when the shares trade at $6.00, a 30% discount designed to make existing shareholders take up their entitlement. The share price adjusts downwards once the new shares are issued.
Example
A distressed retailer's bonds trade at 62 cents on the dollar as lenders question whether the principal will be repaid in full. The deep discount reflects credit risk rather than a mismatch between the coupon and current interest rates.
Formula
Calculation
Discount = Reference value - Market price
Discount percentage = Discount / Reference value
A corporate bond has a face value of $1,000 and pays an annual coupon of 5%, which is $50 a year. It currently trades at $940, so the discount is $1,000 - $940 = $60, which is $60 / $1,000 = 6% of face value. The current yield is $50 / $940 = 5.32%, higher than the 5% coupon rate because the buyer paid less than face value. With three years to maturity, the $60 discount is earned back at $60 / 3 = $20 a year, giving approximate annual income of $50 + $20 = $70. Measured against the average of price and face value, ($940 + $1,000) / 2 = $970, the approximate yield to maturity is $70 / $970 = 7.22%.Case study
Seen in the real world.
Redstone Utilities is a fictional issuer used here purely as an illustrative example. It issued ten-year bonds with a $1,000 face value and a 5% coupon at a time when comparable yields sat at exactly 5%, so the bonds were issued at face value.
Three years later, market interest rates for similar credits had risen to about 7%. Existing Redstone bondholders wanting to sell found buyers only at around $940, a 6% discount to face value, because a buyer could otherwise get 7% elsewhere. Nothing about Redstone's financial health had changed; the discount reflected rates, not risk.
A fictional pension fund bought $2,000,000 of face value at that price, paying $1,880,000. It received $100,000 a year in coupons and, assuming Redstone repaid in full at maturity, would collect the extra $120,000 of discount as well. The illustrative point is that a discount can be an ordinary consequence of rate movements rather than a warning sign.
Watch out
Common mistakes.
- Assuming anything trading at a discount is automatically cheap, when the discount may be an accurate reflection of credit risk or poor prospects.
- Confusing a discount to face value, which is about interest rates and credit, with a discount to net asset value, which is about sentiment and liquidity.
- Comparing a bond's coupon rate with market yields without adjusting for the purchase price, which understates the return earned by a discount buyer.
Questions
People also ask.
Why would a bond trade below face value?
Usually because its fixed coupon is lower than what investors can now earn elsewhere, or because there is doubt about whether the issuer will repay in full.
Does a discount always disappear by maturity?
For a bond that is repaid in full, yes, because the holder receives face value at maturity, but a fund trading below net asset value may stay at a discount indefinitely.
Is buying at a discount taxed differently?
In many jurisdictions the gain from the discount is treated as income rather than capital when the security is held to maturity, so the tax outcome is worth checking before investing.
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