What it means
Instead of paying interest in cash, a discount note builds the interest into the price. A borrower issues a note that will repay $100,000 in six months, and investors pay a little less than $100,000 today.
The gap between the two amounts is the interest the investor earns for waiting. These notes are used by governments, banks and corporations to fund short-term needs.
Because the repayment date is usually a few days to a year away, they suit businesses that need cash to bridge the gap between paying costs and being paid. For investors, they are a way to park spare cash for a defined period with a known outcome.
Pricing uses a discount rate, which is quoted on the face value rather than on the amount actually invested. That convention makes the quoted number look slightly lower than the true return.
To compare a discount note fairly with a savings account or a bond, investors convert the discount rate into a yield based on the price paid. For a corporate treasurer, discount notes are a useful tool on both sides of the balance sheet.
Issuing commercial paper in the form of discount notes can be cheaper than a bank overdraft, while buying them lets the company earn a return on temporary surplus cash. The main risk on the investing side is the credit quality of the issuer, which is minimal for governments and higher for companies.
A nuance is that the investor's gain is generally treated as interest income, even though it arrives as a rise in the value of the note. Companies should record the amortisation of the discount over the life of the note, rather than waiting to recognise it all at maturity.
In practice
Real-world examples.
Example
A government raises short-term cash by selling 91-day notes at a discount to face value. Banks and money market funds buy them because the risk of non-payment is very low. The notes are repaid in full on the due date.
Example
A well-known retailer issues commercial paper before the holiday season to pay for inventory. It sells the paper at a discount and repays the full amount after the holiday sales arrive. The cost is lower than borrowing against a bank facility.
Example
A manufacturing company has $2,000,000 of spare cash for four months before a planned equipment purchase. Its treasurer buys discount notes that mature a week before the payment date. The company earns a modest return without risking the principal.
Formula
Calculation
Price = face value x (1 - discount rate x days / 360)
A company buys a discount note with a face value of $500,000 that matures in 180 days at a discount rate of 3%. The discount is $500,000 x 0.03 x 180 / 360 = $7,500. The price is $500,000 - $7,500 = $492,500. At maturity the company receives $500,000, so it earns $7,500 on an investment of $492,500, a return over the period of 7,500 / 492,500 = 1.52%.Case study
Seen in the real world.
Lakeshore Foods is an illustrative, fictional packaged food company that receives most of its income in the autumn, after paying growers in the summer. Each year it borrowed from a bank at an annual cost of 6.5% to cover a $4,000,000 gap lasting about 120 days.
The finance director arranged to issue discount notes with a face value of $4,000,000, maturing in 120 days, at a discount rate of 5%. The discount was $4,000,000 x 0.05 x 120 / 360 = $66,667, so the company received about $3,933,333 up front.
The bank loan would have cost $4,000,000 x 0.065 x 120 / 360 = $86,667 in interest, so the notes saved about $20,000. The illustrative lesson is that the quoted rate on a discount note must be compared with a loan on a like-for-like basis, and here the saving held even after allowing for fees.
Watch out
Common mistakes.
- Comparing a discount rate with an ordinary interest rate, when the discount rate is quoted on face value and understates the true yield.
- Assuming a discount note pays regular interest, when the whole return arrives at maturity.
- Ignoring issuer risk on company notes, when the return depends on the borrower being able to repay on time.
Questions
People also ask.
How is a discount note different from a coupon bond?
A coupon bond pays periodic interest and returns face value at maturity, while a discount note pays one amount at maturity and sells for less than that amount.
How long do discount notes last?
Usually from a few days to a year, although the exact range depends on the issuer and market.
How do I convert the discount rate to a yield?
Divide the discount earned by the price paid and scale it to a year, which gives a higher figure than the quoted discount rate.
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