Discount bonds: Meaning, Criticisms & Real-World Uses

Discount Bonds

A discount bond is a debt security that trades at a price below its par value. This occurs when the bond's stated coupon rate is lower than the prevailing interest rates in the market, or when investors demand a higher yield for other reasons, such as perceived credit risk. Investing in discount bonds is a fundamental aspect of fixed income investing, where investors seek predictable income streams and capital appreciation.

History and Origin

The concept of bonds trading at a discount or premium is intrinsically linked to the evolution of bond market and the dynamic interplay of supply, demand, and interest rates. While rudimentary forms of debt instruments existed in ancient civilizations, the modern bond market, with its standardized securities and secondary trading, began to take shape centuries ago. As governments and corporations began to issue debt securities to finance large-scale endeavors, the market for these instruments grew. For instance, the first U.S. Treasury bonds, known as "Liberty Bonds," were issued to fund World War I in 1917.⁹

The formalization of central bank policies, such as the Treasury-Federal Reserve Accord of 1951, further influenced bond pricing by separating government debt management from monetary policy, allowing bond yields to be determined more freely by market forces.⁸ Over time, as interest rates fluctuated, the prices of existing fixed-coupon bonds moved inversely. When new bonds were issued with higher coupon rates, older bonds with lower rates became less attractive on an income basis, causing their prices to fall below par to offer a competitive yield to new buyers. Conversely, if interest rates fell, existing bonds with higher coupon rates would trade at a premium.

Key Takeaways

A discount bond is a debt security trading below its face value, typically due to market interest rates being higher than its coupon rate.
Investors in discount bonds receive both periodic interest payments and a capital gain when the bond matures at par.
The yield to maturity of a discount bond will be higher than its coupon rate.
Discount bonds are generally more sensitive to changes in interest rates than bonds trading at a premium or par.
Zero-coupon bonds are a specific type of discount bond that always trade at a discount because they do not pay periodic interest.

Formula and Calculation

The price of a bond, including a discount bond, is calculated as the present value of its future cash flows, which consist of periodic coupon payments and the principal repayment at maturity.

The general formula for the present value of a bond is:

P = \sum_{t=1}^{N} \frac{C}{(1+r)^t} + \frac{F}{(1+r)^N}

Where:

( P ) = Current bond price (market value)
( C ) = Periodic coupon payment
( r ) = Market interest rate or required yield to maturity (discount rate per period)
( F ) = Face value (par value) of the bond
( N ) = Number of periods until maturity

A bond trades at a discount when ( P < F ). This mathematically occurs when ( r > \frac{C}{F} ) (i.e., the market interest rate is greater than the bond's coupon rate relative to its par value).

Interpreting the Discount Bond

When a bond is trading at a discount, it signifies that its promised future cash flows, given its fixed coupon rate, are less attractive compared to current market opportunities. The market adjusts the bond's market value downward to compensate. This allows a new investor to achieve a yield comparable to prevailing market rates.

For instance, if a bond was issued with a 3% coupon rate and new bonds of similar risk are now being issued with 5% coupon rates, the existing 3% bond will trade below its par value to ensure that a buyer can still earn a competitive return. The total return for an investor who purchases a discount bond and holds it to maturity will include both the regular coupon payments and the capital appreciation from the discounted purchase price up to the par value at maturity.

Hypothetical Example

Consider a company, Diversified Corp., that issued a 10-year bond with a par value of $1,000 and a 3% annual coupon rate (paid annually). Two years after issuance, market interest rates for similar bonds have risen to 5%.

Since the bond's 3% coupon rate is now lower than the prevailing 5% market rate, this bond will trade at a discount. Let's calculate its approximate current price. For simplicity, we'll assume annual payments and an 8-year remaining maturity (10 - 2 = 8 years).

Coupon payment (C) = 3% of $1,000 = $30
Face Value (F) = $1,000
Market Rate (r) = 5%
Periods to Maturity (N) = 8

Using the bond pricing formula:

P = \frac{30}{(1+0.05)^1} + \frac{30}{(1+0.05)^2} + \dots + \frac{30}{(1+0.05)^8} + \frac{1000}{(1+0.05)^8}

Calculating this, the bond's price would be approximately $870.47. An investor purchasing this bond for $870.47 would receive $30 in annual interest and, at maturity, receive $1,000, realizing a capital gain of $129.53 ($1,000 - $870.47). The combination of the annual coupon payments and this capital gain provides a total return that approximates the current market yield of 5%.

Practical Applications

Discount bonds appear frequently in various investment scenarios:

Rising Interest Rate Environments: When the Federal Reserve or other central banks raise interest rates, existing bonds with lower coupon rates often fall in price, trading at a discount. This is a direct consequence of the inverse relationship between bond prices and interest rates.⁶, ⁷ The Federal Reserve Bank of St. Louis provides further insight into how interest rate changes influence the bond market.⁵
Secondary Market Trading: Most bonds purchased by individual investors are bought on the secondary market. If market rates have moved since issuance, these bonds will likely trade at a discount or premium.⁴
Zero-coupon bonds: These bonds are explicitly designed to be discount bonds. They do not pay periodic interest but are sold at a deep discount to their par value and mature at par, with the entire return coming from the capital appreciation.
Tax Efficiency: In some jurisdictions, the capital gain realized from a discount bond (the difference between the purchase price and par value at maturity) may be taxed at a lower capital gains rate compared to ordinary income from interest payments. This can be a consideration for investors in higher tax brackets.³
Portfolio Management: Fund managers may intentionally seek out discount bonds to adjust portfolio duration, enhance yield to maturity, or diversify certain risks within a fixed income portfolio.²

Limitations and Criticisms

While discount bonds can offer attractive yields and potential capital gains, they come with certain limitations and risks:

Interest Rate Sensitivity: Discount bonds, particularly those with longer maturities or lower coupon rates, tend to be more sensitive to changes in market interest rates. A small increase in rates can lead to a more significant drop in their market value than for bonds trading at par or a premium.¹ This increased volatility can expose investors to greater price risk if they need to sell before maturity.
Reinvestment Risk: Although a discount bond may offer a higher yield to maturity, the fixed, lower coupon payments (or no payments for zero-coupon bonds) mean less cash flow available for reinvestment at potentially higher future rates.
Liquidity: Some thinly traded discount bonds may have lower liquidity, making them harder to sell quickly without significantly impacting their price.
Callable Bonds: If a discount bond is also a callable bond, the issuer might redeem it early if interest rates fall, preventing the investor from realizing the full capital appreciation to par. This is less common for discount bonds, as call features are usually exercised when rates fall, which would typically cause a bond to trade at a premium.

Discount Bonds vs. Premium Bonds

The primary distinction between discount bonds and premium bonds lies in their trading price relative to their par value and the relationship between their coupon rate and prevailing market interest rates.

A discount bond trades below its par value. This typically occurs when the bond's fixed coupon rate is lower than the current market interest rates for comparable new issues. Investors purchase discount bonds expecting to receive periodic interest payments and a capital gain when the bond matures at its full par value. The yield to maturity of a discount bond will be higher than its coupon rate.

Conversely, a premium bond trades above its par value. This happens when the bond's fixed coupon rate is higher than the current market interest rates. Investors are willing to pay more than par to receive the higher-than-market coupon payments. While they receive higher interest, they incur a capital loss as the bond approaches maturity at its par value. The yield to maturity of a premium bond will be lower than its coupon rate. The confusion often arises because both types of bonds offer fixed income streams, but their upfront cost and total return profile (coupon plus capital gain/loss) differ significantly based on market interest rate dynamics.

FAQs

What causes a bond to trade at a discount?

A bond trades at a discount primarily when the prevailing market interest rates rise above the bond's fixed coupon rate. This makes the bond's coupon payments less attractive compared to newly issued bonds, so its price must drop to offer a competitive yield to maturity. Other factors, such as increased perceived credit risk of the issuer, can also cause a bond's price to fall below par.

Do all bonds mature at par value?

Typically, most bonds are issued with the expectation of maturing at their par value, also known as face value or principal amount. At maturity, the issuer repays the bondholder this par amount. While bonds can trade at a discount or premium in the secondary market before maturity, they are generally redeemed at par, assuming the issuer does not default.

Are zero-coupon bonds always discount bonds?

Yes, zero-coupon bonds are inherently discount bonds. They do not pay regular interest (coupons) during their lifetime. Instead, they are sold at a significant discount to their par value, and the investor's return comes entirely from receiving the full par value when the bond matures. The deeper the discount, the higher the implied yield.