Discount Bond

Discount Bond: Definition and Overview

A discount bond is a debt security issued or trading for less than its par (face) value. This can occur at issuance or in the secondary market. When a bond trades substantially below par—often 20% or more—it’s sometimes called a deep-discount bond. Discount bonds contrast with premium bonds, which trade above par.

How Discount Bonds Work

• Issuers (governments or corporations) borrow money by selling bonds; investors receive periodic interest (coupon) and the face value at maturity.
• If a bond’s coupon rate is lower than comparable market rates, its market price will fall below par so that its yield aligns with prevailing rates.
• Investors who buy at a discount can realize capital appreciation if the bond is held to maturity (receiving full face value), but this benefit assumes the issuer does not default.

Yield to Maturity (YTM)

Yield to Maturity estimates the annual return an investor will earn if the bond is held to maturity, accounting for:
– Current market price
– Par value
– Coupon payments
– Time to maturity

YTM is a comprehensive measure of return; many online calculators can compute it since the formula is algebraically complex.

Special Types of Discount Bonds

• Distressed Bonds: Issued by companies in financial trouble or near bankruptcy. They trade at steep discounts and carry high default risk. Buying distressed bonds is speculative—potentially high reward but large risk of loss.
• Zero-Coupon Bonds: Issued at deep discounts and pay no periodic interest. They deliver the face value only at maturity, so price appreciates over time as maturity approaches.

Why Bonds Trade at a Discount

• Rising market interest rates make existing bonds with lower coupons less attractive, pushing their prices below par.
• Deteriorating issuer creditworthiness or market concerns about default can drive prices down.
• Lower demand for a bond relative to market alternatives can also create discounts.

Pros and Cons

Pros
– Potential for capital gains if held to maturity (buy low, receive full par value).
– Often higher effective yield than comparable premium bonds.
– Available across maturities (short- and long-term), allowing diversification of interest-rate and default exposure.
– Regular coupon payments are typically still paid unless the bond is zero-coupon or the issuer defaults.

Cons
– May indicate higher default risk or financial distress of the issuer.
– Deep discounts often reflect market concerns (falling dividends, poor fundamentals).
– Capital gains may be taxable; investors should consider tax treatment.
– Zero-coupon bonds provide no periodic income.

Discount Bonds, Interest Rates, and Default Risk

• Bond prices and market interest rates move inversely: when rates rise, bond prices fall.
• A bond with a coupon below current market rates will usually trade at a discount to compensate buyers.
• Holding a discount bond through maturity returns face value only if the issuer remains solvent. Default risk is a primary concern—especially for deeply discounted or long-term bonds.

Example

Consider a corporate bond originally offered at par with:
– Coupon: 4.915%
– Maturity: 08/01/2034
– Price at offering: $100

If the bond now trades at $79.943, its price is well below par. If comparable safe yields (e.g., 10-year Treasury) are much lower, this steep discount likely reflects issuer-specific credit concerns. The bond’s market yield can exceed its coupon (sometimes notably higher), signaling higher perceived risk.

When to Consider Buying Discount Bonds

• You seek potentially higher yields and are comfortable with increased credit risk.
• You can assess issuer creditworthiness and are prepared to hold the bond to maturity or accept price volatility.
• You want to diversify fixed-income holdings across maturities and credit profiles.

Key Takeaways

• Discount bonds sell below par and can offer higher yields, but often reflect greater default or credit risk.
• Yield to maturity is the standard way to evaluate expected return, incorporating price, coupons, and time to maturity.
• Deep discounts can signal distress (distressed bonds) or reflect structural features (zero-coupon bonds).
• Evaluate issuer creditworthiness, interest-rate exposure, and tax implications before investing.