What it means
Every bond has a face value, also called par, which is the amount repaid at maturity, and a coupon, which is the fixed interest paid each period. If market interest rates rise above the coupon rate between the time the terms are set and the moment of sale, nobody will pay full face value, so the price drops to a discount.
The commercial significance is that the discount is real money the issuer never receives but must still repay. A company issuing $1,000,000 of bonds at a discount gets less than $1,000,000 in cash yet owes the full $1,000,000 at maturity, and the difference is genuine borrowing cost.
Accounting reflects that by amortising the discount over the bond's life, which means adding a slice of it to interest expense each period. The bond's carrying value on the balance sheet therefore climbs steadily from the issue price towards face value, reaching par exactly at maturity.
Two amortisation methods exist. The straight-line method spreads the discount evenly and is simple to follow, while the effective interest method applies a constant rate to the rising carrying value and is required under most accounting standards because it reflects the true cost more faithfully.
A discount is not a sign of distress on its own. Most discounts simply reflect the direction of interest rates since issue, though a deep discount on an existing bond in the secondary market can also signal that investors doubt the issuer will repay.
In practice
Real-world examples.
Example
A regional bank issues 3% bonds a fortnight after the central bank raises rates. Investors will only buy at 96 cents on the dollar, so the bank records a 4% discount and quietly notes that its effective funding cost is nearly a full percentage point above the coupon.
Example
A finance manager preparing statutory accounts spots that a colleague booked the $80,000 discount as an immediate expense at issue. She corrects it, spreading the cost across five years, which lifts reported profit in the year of issue and reduces it in each of the following four.
Example
A pension fund buys an existing corporate bond in the secondary market at 88 because rates have risen since it was launched. The fund is happy to hold to maturity, since the $120 per $1,000 pull towards par adds to its return regardless of what the coupon pays.
Think of it
“Bond discount is below face value-cheaper because coupon is below market rates.
Formula
Calculation
Bond discount = face value - issue proceeds
Annual discount amortisation (straight-line) = bond discount / years to maturity
Annual interest expense = cash coupon paid + annual discount amortisation
A logistics company issues $1,000,000 of five-year bonds with a 4% annual coupon. Because market rates have moved up, the bonds sell at 92, meaning 92% of face value, so proceeds are $1,000,000 x 0.92 = $920,000 and the discount is $1,000,000 - $920,000 = $80,000.
Under the straight-line method the annual amortisation is $80,000 / 5 = $16,000. Each year the company pays cash interest of $1,000,000 x 4% = $40,000 and records total interest expense of $40,000 + $16,000 = $56,000. The carrying value rises from $920,000 to $920,000 + $16,000 = $936,000 after the first year and continues climbing to $1,000,000 by maturity.
Over the full five years the company pays out 5 x $40,000 = $200,000 in coupons plus the $80,000 discount, giving a total borrowing cost of $280,000 on $920,000 of cash actually received.Case study
Seen in the real world.
This is an illustrative and fictional case. Meridian Rail Components, an invented parts manufacturer, agreed the terms of a $25,000,000 bond in March at a 5% coupon but did not complete the issue until June, by which time market yields for comparable credits had reached 6%.
The fictional bonds priced at 94, raising $23,500,000 and creating a discount of $1,500,000 over a six-year life. Meridian's board initially read the shortfall as a failed fundraising, since the plant it wanted to build had been costed at $25,000,000.
The finance director reframed it correctly: the company had not lost $1,500,000, it had borrowed $23,500,000 at an effective cost near 6% rather than the 5% coupon suggested. The imagined board approved a smaller first phase of the plant, and the annual accounts showed interest expense of roughly $1,250,000 in the first year against cash coupons of $1,250,000, with the discount amortisation pushing recorded cost above the cash paid.
Watch out
Common mistakes.
- Treating the discount as a one-off loss at issue rather than additional interest spread over the bond's life.
- Quoting the coupon rate as the cost of borrowing when a discount means the true cost is higher.
- Confusing a discount created by rising market rates with one created by doubts about the issuer's ability to repay.
Questions
People also ask.
Does a bond discount reduce the amount the company must repay?
No, the full face value is still due at maturity regardless of what investors originally paid.
Which amortisation method should be used?
The effective interest method is required by most accounting standards, with straight-line acceptable only when the difference is immaterial.
What is the opposite of a bond discount?
A bond premium, where the coupon is above market rates and investors pay more than face value.
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