What Is Discounts?
In finance, a discount refers to a situation where an asset's price is less than its par value, face value, or perceived intrinsic value. This concept is fundamental to the broader field of Valuation and plays a crucial role in investment analysis, particularly in fixed income securities and closed-end funds. When an asset trades at a discount, it implies that its current market price is lower than a benchmark price.
History and Origin
The concept of a discount in financial instruments, particularly bonds, dates back centuries. Historically, bonds were issued with a stated coupon rate, and their prices would fluctuate in the secondary market based on prevailing Interest Rates and the creditworthiness of the issuer. When market interest rates rose above a bond's fixed coupon rate, the bond's price had to fall below its face value to offer investors a competitive yield, thus creating a discount. Conversely, if interest rates fell, the bond would trade at a premium.
This inverse relationship between bond prices and interest rates is a cornerstone of fixed-income analysis and has been observed throughout financial history. For example, periods of rising interest rates, such as those implemented by central banks to combat inflation, typically lead to existing bonds trading at a discount to their face value to align their Yield with the new market rates. Reuters published an explainer on how interest rate hikes affect bond prices and yields, illustrating this long-standing principle.
Key Takeaways
- A discount occurs when an asset's market price is below its face value, par value, or intrinsic value.
- Commonly observed in Bonds when market interest rates rise above the bond's coupon rate.
- Closed-end funds can trade at a discount to their net asset value (NAV), reflecting market sentiment or illiquidity.
- For investors, purchasing assets at a discount can present opportunities for potential Capital Gains if the price reverts to its intrinsic or par value.
- Original Issue Discount (OID) bonds are intentionally issued at a discount and represent a specific type of debt instrument.
Formula and Calculation
For bonds, a discount is observed when the Market Price of the bond is less than its Face Value (also known as par value). While there isn't a single "discount formula," the price of a bond (P) trading at a discount can be calculated using the present value of its future cash flows (coupon payments and face value) discounted at the market's required yield (YTM).
The price of a bond is:
Where:
- (P) = Current market price of the bond
- (C) = Annual coupon payment
- (F) = Face value (par value) of the bond
- (r) = Market interest rate or yield to maturity (YTM)
- (N) = Number of periods to maturity
If (P < F), the bond is trading at a discount.
For closed-end funds, the discount is calculated as:
Where NAV is the Net Asset Value per share of the fund's underlying holdings.
Interpreting Discounts
The interpretation of a discount depends heavily on the asset class. For bonds, a discount primarily reflects changes in Interest Rates since the bond's issuance. If a bond is trading at a discount, it means its stated coupon rate is lower than the current prevailing market rates for similar bonds, or there is an increased perception of Risk regarding the issuer's ability to make payments. Investors buying a bond at a discount will realize a return not only from the coupon payments but also from the price appreciation as the bond approaches its maturity, at which point it will be redeemed at its face value (assuming no default).
For closed-end funds (CEFs) and certain other investment vehicles like real estate investment trusts (REITs) or even publicly traded operating companies, a discount to Net Asset Value (NAV) or intrinsic value can reflect various factors. These include market sentiment, the fund's liquidity, management fees, investment strategy, or even tax implications. A significant discount in a closed-end fund might signal that investors are pessimistic about the fund's future performance or its underlying assets.
Hypothetical Example
Consider a newly issued bond with a face value of $1,000 and an annual coupon rate of 5%, maturing in 10 years. Suppose that shortly after issuance, prevailing market interest rates for similar bonds rise to 6%. Because the bond's fixed 5% coupon is now less attractive than new bonds paying 6%, its market price will fall below its face value.
An investor might purchase this bond in the secondary market for $926.40. This $926.40 represents a discount from its $1,000 face value. This discount arises because the bond's cash flows (annual $50 coupon payments and $1,000 at maturity) are now discounted back to the present at the higher 6% market rate. If the investor holds the bond to maturity, they will receive the full $1,000 face value, thus realizing a Capital Gains of $73.60, in addition to the coupon payments.
Practical Applications
Discounts appear in various areas of finance:
- Fixed-Income Securities: Bonds are the most common example. Bonds can trade at a discount due to rising interest rates, increased credit risk of the issuer, or specific tax treatments like Original Issue Discount (OID) bonds. The U.S. Internal Revenue Service (IRS) provides detailed guidance on the taxation of OID, which is income earned from a bond purchased at a discount. IRS.gov - Original Issue Discount (OID)
- Closed-End Funds (CEFs) and Exchange-Traded Funds (ETFs): While Exchange Traded Funds typically trade very close to their NAV, CEFs frequently trade at a discount or premium to their Net Asset Value. This can be due to factors like Liquidity concerns, management performance, or market perception. Morningstar has published research exploring what drives these discounts and premiums in closed-end funds.
- Equity Markets: Sometimes, companies might issue new shares to existing shareholders at a discount to the current Stocks market price in a rights offering. Similarly, private companies may offer employees stock options or shares at a discount to an expected future valuation.
- Asset Sales: In distressed situations or during liquidations, assets (e.g., real estate, portfolios of loans) may be sold at a significant discount to their perceived market value to facilitate a quick sale.
- Preferred Stock: Preferred Stock can also trade at a discount to its par value, especially if interest rates rise or the issuing company's credit quality declines, impacting the perceived safety of its fixed Dividends.
Limitations and Criticisms
While buying at a discount can appear attractive, several limitations and criticisms exist:
- Value Trap Risk: An asset trading at a discount may be genuinely undervalued, but it could also be a "value trap" where the discount reflects fundamental problems with the asset or its issuer that may not improve. For example, a bond trading at a steep discount due to severe credit risk might default, leading to significant losses.
- Market Inefficiency vs. Information: A persistent discount in a closed-end fund might suggest market inefficiency, but it could also be a rational reflection of factors like illiquidity, high fees, or tax liabilities within the fund. Investors on forums like Bogleheads.org often discuss the nuances of closed-end fund discounts, weighing potential opportunities against inherent structural issues. Bogleheads.org Forum - Closed-end Fund (CEF) Discounts/Premiums
- Interest Rate Risk: For discounted bonds, if interest rates continue to rise after purchase, the bond's price could fall further, leading to additional unrealized losses if sold before maturity.
- Tax Implications: While a discount might lead to capital gains, these gains are typically taxable. For Original Issue Discount (OID) bonds, the discount is often accrued as taxable income annually, even if the investor doesn't receive cash until maturity. This can create a "phantom income" tax liability.
Discounts vs. Premium
The concept of a discount is often contrasted with a premium. While a discount means an asset's market price is below its par or intrinsic value, a premium means the market price is above that benchmark.
| Feature | Discount | Premium |
|---|---|---|
| Price vs. Par | Market Price < Face Value / Intrinsic Value | Market Price > Face Value / Intrinsic Value |
| Bonds | Occurs when market yield > coupon rate | Occurs when market yield < coupon rate |
| CEFs | Market Price < Net Asset Value (NAV) | Market Price > Net Asset Value (NAV) |
| Implication | Often suggests higher effective yield or perceived undervaluation | Often suggests lower effective yield or perceived overvaluation |
| Investor View | Potential for capital gains to par/NAV | Potential for capital loss to par/NAV |
Understanding the difference between an asset trading at a discount or a Premium is critical for investors, as it directly impacts their effective Return on Investment and risk profile.
FAQs
What does it mean if a stock is trading at a discount?
If a stock is described as trading at a discount, it typically means its current Market Price is considered to be below its fundamental or intrinsic value, as determined by analysts or investors. This could suggest that the company's earnings, assets, or future growth potential are not fully reflected in its share price.
Why do bonds trade at a discount?
Bonds primarily trade at a discount when prevailing market Interest Rates rise above the bond's fixed coupon rate. This makes the bond's regular interest payments less attractive compared to newer bonds, so its price must fall to offer a competitive yield. Increased credit risk of the issuer can also cause a bond's price to trade at a discount.
Can a discount fund generate a higher return?
A closed-end fund (CEF) trading at a discount has the potential to generate a higher return if the discount narrows or disappears, in addition to the returns from its underlying investments. If the fund's Market Price moves closer to its Net Asset Value (NAV), investors benefit from both the NAV performance and the discount narrowing. However, there is no guarantee the discount will narrow, and it could even widen.