Definition
A Discount Bond is a bond that is sold for less than its face value, or par value. The discount amount represents the difference between the purchase price and the par value, which will be repaid to the bondholder at maturity. The discount is effectively the interest the bondholder receives.
Phonetic
The phonetic spelling of “Discount Bond” is:/ˈdɪskaʊnt bɒnd/
Key Takeaways
- A discount bond is a bond that is issued for less than its par or face value. This means it’s sold at a price lower than the face value. These are often long-term, interest-bearing securities issued by governments and corporations.
- Discount bonds do not pay annual interest. Instead, the bondholder receives the gain of the face value of the bond over what they paid for it at maturity. This difference is often considered as the interest earned on the bond.
- The pricing of discount bonds are influenced by several factors including the creditworthiness of the issuer, time until maturity, and interest rates. If the credibility of the issuer is high and the interest rates are low, the discount on the face value of the bond is likely to be less. On the other hand, if the interest rate rises or the credibility of the issuer declines, the discount might increase, lowering the bond’s price.
Importance
The term “Discount Bond” is important in the world of business and finance because it provides investors with the opportunity to purchase a bond below its face value, thus promising a higher yield upon maturity. The appreciated value from its discounted price to its nominal or par value is the investor’s profit. It’s crucial for understanding debt markets, making investment decisions, pricing bonds and assessing the risk and reward of specific investments. The concept of a discount bond also illustrates the principle that money available now (present value) is worth more than the same amount in the future due to its potential earning capacity. This forms the basis of time value of money concept.
Explanation
Discount bonds are primarily used as a tool for raising capital in business and finance. By issuing bonds at a discount, i.e., selling for less than their face value, a company can attract investors looking for investment opportunities that promise a profit in the future. The promising return at maturity offers an incentive for investors to purchase the bond. The capital raised from the bond issue can be used to fund business operations, repay debts, or invest in new projects or ventures. In this way, discount bonds offer corporations a valuable alternative to equity financing, which might otherwise dilute ownership stakes.Meanwhile, discount bonds also function as an important instrument in monetary policy. Central banks often buy and sell government bonds to adjust the money supply and influence interest rates. When central banks want to increase the money supply and lower interest rates, they might buy back bonds, effectively releasing money into the economy. Alternatively, selling bonds can serve to pull money out of circulation, therefore reducing the money supply and increasing interest rates. The dynamics of discount bonds, therefore, have far-reaching implications for economic conditions and monetary stability.
Examples
1. U.S. Treasury Bonds: One of the most common examples of a discount bond are U.S. Treasury Bills (T-Bills). The U.S. government issues these bonds at a discount of their face value. For instance, a $1,000 T-Bill might be sold for $950. After the bond matures, the holder is paid the full face value. The $50 difference between the purchase price and the face value is the investor’s return.2. Corporate Bonds: Another example is when corporations issue discount bonds to raise capital. If a firm wants to raise $1,000, it might issue a bond at a discounted rate of $900. The investor will pay $900 and at maturity, they receive $1,000. The $100 is the return or the interest earned on the bond.3. Municipal Bonds: Municipalities or local governments also issue discount bonds to fund projects like infrastructure or schools. For example, a city may issue a bond with a face value of $10,000 for a road improvement project, but sell it for $9,500. Once the bond matures, the holder will receive the full face value of the bond, thus earning $500 in returns.
Frequently Asked Questions(FAQ)
What is a Discount Bond?
A discount bond is a type of bond that is sold for less than its face value. The bond will mature at its face value, allowing the bondholder to make a profit by redeeming it at a price higher than what they paid.
How does a Discount Bond work?
The bondholder purchases the bond at a price lower than its face value. Over time, the bond increases in value until it reaches its full face value at maturity. The investor makes a profit from this difference.
Is the yield on a Discount Bond higher or lower than its face value?
The yield on a discount bond is higher than its face value. This is because the bond is purchased at a discount, but at maturity, the investor receives the full face value.
How do I calculate the yield of a Discount Bond?
The yield (or discount yield) of a discount bond can be calculated using the formula: Yield = (Face Value – Purchase Price) / Face Value * (365 / Days till Maturity)
What is the difference between a Discount Bond and a Premium Bond?
A discount bond is bought for less than its face value and will increase to its face value at maturity. A premium bond, on the other hand, is bought for more than its face value. The investor is willing to pay more upfront due to the bond offering coupon payments, or interest, that is above the prevailing market rate.
What are the risks of investing in a Discount Bond?
The main risk of investing in a discount bond is the possibility that the issuer might default on its payments. Additionally, discount bonds are sensitive to interest rate changes. If rates rise, the price of the bond may decrease.
Can a corporate bond be a Discount Bond?
Yes, any bond, including corporate, municipal, or government, can be issued as a discount bond if it’s sold for less than its face value.
Do Discount Bonds pay interest?
Discount bonds, like zero-coupon bonds, generally don’t make regular interest payments. Instead, the investor makes a return on the investment when the bond matures at its higher face value.
Related Finance Terms
- Face Value: This refers to the value or the principal amount of a security that is paid to the holder at the time of maturity. It’s also known as the par value.
- Coupon Rate: This is the interest rate stated on a bond when it’s issued, which is used to calculate the payments for the bondholder.
- Yield to Maturity (YTM): This represents the total return a bondholder can earn if the bond is held until it matures.
- Market Value: This refers to the current price of the bond in secondary markets. The market price of a bond may be above or below par, reflecting the current economic environment and the financial health of the issuer.
- Maturity Date: The date on which the principal amount of a bond is to be paid to the bondholder. It is also when the debt obligation ends.
