What it means
Most bonds pay regular interest payments, called coupons, and then return the original sum at the end. A pure discount instrument skips the coupons entirely.
Instead, you buy it for less than its face value and wait; the profit comes when the issuer pays the full amount on the maturity date. The price you pay depends on the interest rate investors require and the time remaining.
The longer the wait or the higher the required return, the bigger the discount. A bill that matures in a month sells very close to face value, while one that matures in ten years sells far below it.
These instruments are widely used by governments and companies. Short-term government bills and commercial paper (short-term borrowing by large companies) are standard examples.
Businesses use them to park spare cash for a known period and to match a known future payment, such as a tax bill due in three months. One feature that surprises many people is that the investor may owe tax each year on the gradual increase in value, even though no cash has been received.
This is because tax rules in many countries treat the yearly accrual of the discount as income. Finance teams should therefore check how the local rules apply before buying long-dated versions.
Pure discount instruments are also sensitive to changes in interest rates. Because all the cash arrives at the end, their prices move more sharply than coupon-paying bonds of the same maturity when rates change.
This makes long-dated ones attractive to investors who want to lock in a known future sum but risky for those who may need to sell early. A nuance is that the return is quoted in different ways.
Some markets quote a discount rate, calculated on the face value, and others quote a yield, calculated on the price paid. The yield is always a little higher than the discount rate, so it is important to know which one you are looking at.
In practice
Real-world examples.
Example
A manufacturer expects to pay a $200,000 tax bill in six months. The treasurer buys government bills maturing just before that date for about $194,000. At maturity the bills pay $200,000, covering the tax payment with no interest rate guesswork.
Example
A pension fund buys a 20-year zero-coupon bond to match a lump sum it must pay a retiring member in 20 years. The bond costs a small fraction of its face value today. Because nothing is paid in between, there is no reinvestment worry along the way.
Example
A technology company with surplus cash buys a 90-day commercial paper instrument at a discount from a highly rated issuer. It earns a small return over three months while keeping the money available for the next payroll run.
Formula
Calculation
Price = face value / (1 + yield) ^ years to maturity
Return over the holding period = (face value - price) / price
Suppose a company buys a one-year instrument with a face value of $10,000 for $9,500. The dollar gain is 10,000 - 9,500 = $500. The return is 500 / 9,500 = 0.0526, or 5.26%. Using the pricing formula in reverse, 10,000 / 1.0526 = $9,500, confirming that a yield of about 5.26% explains the price.Case study
Seen in the real world.
Meridian Tools is an illustrative, fictional equipment maker that needed to repay a $2,000,000 loan in exactly three years. The finance director wanted certainty about having the cash on that date rather than hoping to accumulate it from operating profits.
She bought pure discount instruments with a combined face value of $2,000,000 maturing the week before the loan fell due. They cost about $1,700,000 today, with the difference representing the return over three years. Because the securities paid no coupons, there was no cash to reinvest along the way and no uncertainty about the final amount.
The illustrative trade-off was that the company's $1,700,000 was tied up and could not be used elsewhere. The directors decided that the certainty was worth it, since the repayment date was fixed and a shortfall would have triggered penalties.
Watch out
Common mistakes.
- Assuming a pure discount instrument pays interest, when its whole return comes from buying below face value and being repaid at face value.
- Ignoring tax on the annual accrual of the discount, even though no cash has been received until maturity.
- Comparing a quoted discount rate with a yield on another investment as if they were the same measure, when they are calculated on different bases.
Questions
People also ask.
Is a zero-coupon bond the same as a pure discount instrument?
Yes, in practice they describe the same structure, with a zero-coupon bond being the common name for a longer-dated one.
Why are long-dated pure discount instruments so volatile?
All the cash comes at the end, so a small change in interest rates changes the present value a lot over a long period.
Can the price ever be above face value?
It is rare, and it can only happen if yields are negative, because investors would then accept paying more than they receive back.
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