Discount security

What Is Discount Security?

A discount security is a type of debt instrument that is sold at a price lower than its face value and matures at its face value. The difference between the purchase price and the face value represents the interest or return earned by the investor. These financial instruments are a fundamental component of the fixed income market, primarily used by governments and corporations for short-term debt financing. The most common example of a discount security in the U.S. market is a Treasury Bill (T-bill).

History and Origin

The concept of issuing debt at a discount rather than with periodic interest payments gained prominence with the evolution of government borrowing. In the United States, Treasury Bills, the archetypal discount security, were introduced in 1929. Prior to their introduction, the U.S. Treasury largely relied on fixed-price subscription offerings of coupon-bearing certificates of indebtedness, notes, and bonds. This system had several drawbacks, including underpricing new securities to ensure successful offerings and an infrequent issuance schedule that led to the Treasury borrowing in advance of its needs⁵.

To address these inefficiencies, President Herbert Hoover signed legislation on June 17, 1929, allowing the Treasury to begin offering the new securities. Instead of fixed prices, these bills were auctioned, leading to pricing more consistent with prevailing market prices⁴. The initial auctions and regular issuance of Treasury Bills in the early 1930s provided a reliable mechanism for the government's short-term borrowing needs, eventually replacing older forms of short-term financing like certificates of indebtedness by the end of 1934. The shift to a discount basis for short-term government debt marked a significant change in how public debt was managed and laid the groundwork for modern money market operations. A detailed timeline of U.S. Treasury Bills can be found on the TreasuryDirect website³.

Key Takeaways

• A discount security is bought below its face value and pays its face value at maturity date.
• The investor's return comes from the difference between the purchase price and the face value.
• Treasury Bills are a prime example of discount securities, widely used for short-term government financing.
• These securities are typically short-term, with maturities ranging from a few days to one year.
• They are often considered low-risk investment products due to the creditworthiness of the issuer.

Formula and Calculation

The yield of a discount security is typically calculated based on its discount rate, or more commonly, its bond equivalent yield (BEY) to allow for comparison with interest-bearing securities.

The formula for the discount yield ( (Y_d) ) is:

[ Y_d = \frac{\text{Face Value} - \text{Purchase Price}}{\text{Face Value}} \times \frac{360}{\text{Days to Maturity}} ]

Where:

• Face Value = The value the investor receives at maturity.
• Purchase Price = The price paid for the security.
• Days to Maturity = The number of days remaining until the security matures.
• 360 = The number of days used in the money market convention for calculating discount yields.

The bond equivalent yield (BEY) converts the discount yield into an annualized simple interest rate, making it comparable to coupon-bearing bonds:

[ BEY = \frac{\text{Face Value} - \text{Purchase Price}}{\text{Purchase Price}} \times \frac{365}{\text{Days to Maturity}} ]

This formula provides a more accurate representation of the investment's true yield over its holding period.

Interpreting the Discount Security

Interpreting a discount security primarily involves understanding its implied interest rate or yield. Since these securities do not pay periodic interest, the return is "built-in" through the discount. A lower purchase price relative to the face value indicates a higher effective yield for the investor, assuming the face value remains constant.

Investors evaluate discount securities based on their maturity and the prevailing market interest rates. For instance, if a discount security with a face value of $1,000 and 90 days to maturity is purchased for $990, the $10 difference represents the investor's profit. This profit, when annualized, determines the investment's effective yield. Because many discount securities, such as Treasury Bills, are considered to have virtually no default risk, they are often used as a benchmark for the risk-free rate in financial models. Their liquidity and short maturity periods also make them popular in the money market.

Hypothetical Example

Consider an investor purchasing a newly issued 26-week (182-day) Treasury Bill, a classic example of a discount security. The Treasury Bill has a face value of $10,000.

1. Purchase: The investor participates in an auction and bids successfully, purchasing the T-bill for $9,850.
2. Discount: The discount is the difference between the face value and the purchase price: $10,000 - $9,850 = $150.
3. Maturity: After 26 weeks (182 days), the Treasury Bill reaches its maturity date.
4. Redemption: The investor receives the full face value of $10,000.

The investor's profit from this discount security is $150. To calculate the bond equivalent yield (BEY) for comparison:

[ BEY = \frac{10000 - 9850}{9850} \times \frac{365}{182} ]

[ BEY = \frac{150}{9850} \times 2.00549 \approx 0.015228 \times 2.00549 \approx 0.0305 ]

Thus, the bond equivalent yield for this hypothetical T-bill is approximately 3.05%. This simple scenario illustrates how the investor earns a return solely from the discount at which the security is purchased.

Practical Applications

Discount security instruments have several practical applications across finance and investing:

• Government Financing: Governments around the world use discount securities, such as Treasury Bills, to manage their short-term borrowing needs and fulfill immediate budgetary requirements. These are often auctioned regularly in the primary market through platforms like TreasuryDirect in the United States², which allows individual investors to purchase government securities directly.
• Corporate Short-Term Funding: Corporations issue commercial paper, a form of discount security, to meet their short-term liquidity needs for operations or inventory financing.
• Money Market Instruments: Discount securities are foundational to the money market, providing highly liquid, short-duration investment options for institutions and individuals seeking to park cash safely for short periods.
• Interest Rate Benchmarks: The yields on discount securities, particularly Treasury Bills, serve as key benchmarks for short-term interest rates in the broader economy. Their auction process directly influences short-term rates. The Federal Reserve Bank of New York has detailed the historical context and impact of T-bill auctions on financial markets¹.
• Safe-Haven Investments: Due to their typically low risk, especially government-issued discount securities, they are considered safe-haven investments during periods of market uncertainty, providing capital preservation.

Limitations and Criticisms

While discount securities offer benefits, they also have limitations and potential criticisms:

• Lower Returns: Historically, discount securities, especially those issued by highly creditworthy entities like governments, tend to offer lower returns compared to longer-term debt or riskier assets. This is because the implicit yield reflects their low risk and high liquidity.
• Inflation Risk: The fixed face value payment at maturity means that the purchasing power of the return can be eroded by inflation, particularly over longer holding periods, although most discount securities are short-term.
• Reinvestment Risk: For investors who frequently roll over maturing discount securities, there is a risk that future yields may be lower, impacting their overall returns.
• Yield Curve Implications: The attractiveness of discount securities is heavily influenced by the shape of the yield curve. In an inverted yield curve environment, shorter-term discount securities might offer higher yields than longer-term bonds, but this is an atypical market condition.
• Limited Capital Appreciation: Unlike some other financial instruments, discount securities are not typically purchased with the expectation of capital appreciation. Their value is primarily tied to their approaching maturity at face value, rather than significant price fluctuations in the secondary market.

Discount Security vs. Zero-Coupon Bond

The terms discount security and zero-coupon bond are often used interchangeably due to their shared characteristic of being bought at a discount and maturing at face value without periodic interest payments. However, there's a subtle distinction primarily related to maturity.

• A discount security is a broad term that encompasses various debt instruments sold at a discount, typically referring to short-term instruments like Treasury Bills or commercial paper, which usually mature in less than a year.
• A zero-coupon bond, while also sold at a discount, generally refers to longer-term debt instruments, often with maturities extending several years or even decades. The longer maturity allows for a more substantial discount from the face value.

Both rely on the difference between the purchase price and the face value for their return. The core differentiating factor is typically the maturity date.

FAQs

What is the primary benefit of a discount security?

The primary benefit of a discount security is its simplicity and often low risk, especially when issued by a highly creditworthy entity like a government. Investors know upfront the exact return they will receive at maturity date.

Are Treasury Bills discount securities?

Yes, Treasury Bills (T-bills) are the most well-known example of a discount security in the U.S. market. They are sold at a discount to their face value and mature at par, with the difference constituting the investor's return.

How do I buy a discount security?

You can purchase many discount security instruments, such as Treasury Bills, directly from the U.S. Treasury through its online platform, TreasuryDirect, or through a brokerage account. This allows investors to access government securities.

Do discount securities pay interest?

No, discount securities do not pay periodic interest payments like traditional bonds. Instead, the interest is implicitly earned from the difference between the discounted purchase price and the full face value paid at maturity.