What it means
Every bond has a face value, usually $1,000 or a multiple of it, and a coupon, which is the fixed annual interest rate printed on it. When market interest rates rise above the coupon, nobody will pay full price for a bond that pays less than newer alternatives.
The price falls until the bond's total return matches what the market wants, and at that point the bond is said to trade at a discount. Discounts also appear when investors see more risk in the issuer.
If a company's finances weaken, buyers demand a higher return, so the price of its existing bonds drops below face value. A deep discount can therefore be a warning sign as well as a bargain.
Zero-coupon bonds are discount bonds by design. They pay no interest at all and are issued well below face value, with the whole return coming from the difference between the purchase price and the amount repaid at maturity.
Governments and companies use them to raise money without paying cash interest along the way. A discount bond is pulled back towards face value over time, a process called accretion or pull to par.
For accounting purposes, an investor who holds the bond to maturity gradually recognises the discount as extra interest income each year, and an issuer gradually expenses it. Tax treatment of this accrued discount varies by country, so it is worth checking before buying.
The nuance is that a discount is not automatically a bargain. The price fell for a reason, and the investor should compare the yield to maturity, which includes the gain at the end, with the yield on other bonds of similar risk and term.
In practice
Real-world examples.
Example
A retailer issues $5,000,000 of bonds with a 3% coupon just before central banks raise interest rates. New bonds now pay 5%, so the older bonds trade at 95 cents on the dollar. A pension fund buys some at the discount and enjoys both the coupon and the pull back to face value.
Example
A mid-sized manufacturer reports weak results, and the market begins to doubt its ability to repay debt. Its bonds fall from $1,000 to $780. The treasurer notes that refinancing will now cost the company more than it once expected.
Example
A government sells a savings bond for $750 that will repay $1,000 in ten years. The buyer gets no interest payments, but the $250 gain at the end gives a steady annual return. Many households use such bonds to save for a child's education.
Formula
Calculation
Price of a zero-coupon discount bond = face value / (1 + yield) ^ years
A company issues a 2-year zero-coupon bond with a face value of $1,000. Investors require a yield of 6% a year. Price = $1,000 / (1.06 x 1.06) = $1,000 / 1.1236 = $890.00. The discount is $1,000 - $890 = $110, which is 11% of face value. An investor who buys at $890 and holds to maturity receives $1,000, a gain of $110.Case study
Seen in the real world.
Greenfield Utilities is an illustrative, fictional power company that issued $20,000,000 of 10-year bonds with a 4% coupon when market rates were 4%, so the bonds sold at face value. Two years later, rates in the market had climbed to 6% and the bonds fell to about $0.88 on the dollar.
Greenfield's finance director considered buying back the bonds in the market. Repurchasing $20,000,000 of face value at 88% would cost $17,600,000, producing an accounting gain of $2,400,000 on retiring the debt.
The company decided against it, because replacing the debt would require new borrowing at 6% instead of 4%, which would increase annual interest by $400,000. The illustrative lesson is that a discount on your own debt is a gain only if you do not have to replace the cheap funding at today's higher rates.
Watch out
Common mistakes.
- Assuming a bond selling at a discount is always a bargain, when the lower price often reflects higher market rates or higher risk.
- Comparing only the coupon rate of two bonds, when the yield to maturity includes the discount and is the fairer measure.
- Forgetting that the discount unwinds over time, so the price tends to move towards face value as maturity approaches if the issuer remains sound.
Questions
People also ask.
What is the opposite of a discount bond?
A premium bond, which sells for more than face value because its coupon is higher than what the market currently offers.
Do discount bonds pay interest?
Most pay a coupon, but zero-coupon bonds pay none and deliver all their return as the gain between price and face value.
Is the discount taxable?
Often the accrued discount is treated as income, but the timing and treatment vary by country and by type of bond.
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