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Bond Discount



Definition

A bond discount is the difference between the face value of a bond and the price for which it is sold to the investor. It occurs when the market interest rate is higher than the coupon rate of the bond. Essentially, bond discount refers to a bond that is issued or sold at a lower price than its face value.

Phonetic

The phonetic spelling of “Bond Discount” is: bɒnd dɪsˈkaʊnt

Key Takeaways

  1. Bond Discount Basics: When the market interest rate is higher than the coupon rate of a bond, those bonds are issued at a discount. This means that the bond’s issue price is lower than its face value. A bond discount effectively represents the difference between the bond’s par value and the actual amount paid by the investor.
  2. Interest Payments and Bond Discount: Despite being issued at a discount, these bonds still pay the nominal interest rate to investors. But since investors pay less for a bond sold at a discount, their actual yield is higher than the stated interest rate. This compensates for the lower initial cost.
  3. Amortization of Bond Discount: Bond discount is gradually reduced over the term of the bond via a process called amortization. It’s eventually eliminated by the bond’s maturity as it converges to its par value, and the bond’s book value matches the bond’s face value at maturity.

Importance

A bond discount is an important concept in the field of business and finance because it directly impacts the profitability of an investment in bonds. It refers to the difference between the face value of a bond and the price at which it’s sold to the investor when that price is lower than the face value. The bond discount serves as a form of interest income for the bondholder as the issuer is obligated to pay back the full face value of the bond at maturity. As such, the investor’s overall returns are increased by the difference. Understanding bond discounts can help investors assess the potential profitability of bond investments, plan for future cash flows, and make more informed decisions.

Explanation

A bond discount serves a significant purpose in the finance and business sector as it provides businesses with an alternative financing route and offers a form of return for investors. When a company feels the need to generate additional capital, they have the option to issue bonds, borrowing money from investors with the promise to return it with interest at a future date. However, to make these bonds more attractive to buyers, they sometimes decide to issue them at a less price than their face value, a practice known as offering a bond discount. Essentially, it allows companies to leverage their future profits for immediate cash flow that can be utilized for current operational needs, without increasing their current liabilities excessively.For the bond buyers or investors, a bond discount serves as a form of return on their investment. What they purchase for less today, they are promised an increased value in the future. This represents their earnings or interest on the bond. By buying the bond at a discount, they are practically securing a guaranteed rate of return, considering the issuer doesn’t default. Thus, the prospect of earning this difference, between the lower purchase price and the higher face value, increases the appeal of these bonds to market investors. Also, it helps investors diversify their investment portfolios with a relatively low-risk investment.

Examples

1. U.S. Treasury Bonds: When the Federal government borrows money, it usually does so by issuing bonds. If interest rates rise after the issuance, the market price of these older, lower-yielding bonds will fall, leading to their trading at a discount. For instance, if a $1,000 bond with a coupon rate of 3% is issued and market rates rise to 5%, the bond’s price can drop below $1,000 (par value) to reflect the fact that newer bonds now offer higher returns. 2. Corporate Bonds: In case a Corporation issues a bond but due to certain unforeseen circumstances or a poor credit rating, investors may perceive it as risky. So the bond would sell at a discount to its face value. For example, a company may sell a bond with a face value of $1,000 for $950 to make it more attractive to investors and compensate for the risk.3. Municipal Bonds: Municipal bonds are issued by city or state governments. For instance, if a city issues bonds to fund infrastructure projects, but later local economic conditions decline, the market may perceive more risk that the city won’t make the scheduled interest or principal payments. As a result, the bonds may sell at a discount. Example: A $5000 municipal bond may sell for $4500 because of increased default risk.

Frequently Asked Questions(FAQ)

What is a Bond Discount?

A bond discount refers to a situation when a bond is sold for a price less than its face value or par value. This usually happens when the coupon rate is less than the prevailing interest rate in the market.

What causes a Bond Discount?

A bond discount is typically caused by an increase in market interest rates, making the bond’s lower coupon rate less attractive to investors. As a result, the bond must be sold at a discount to make it more appealing.

How does Bond Discount impact investors?

For investors, purchasing a bond at a discount can provide higher yield-to-maturity due to the difference between the purchase price and the bond’s par value at maturity.

How is Bond Discount recorded in account books?

Bond discount is recorded as a contra account which gets amortized over the life of the bond. The discount is gradually written off to interest expense over the life of the bond.

What is the difference between Bond Discount and Bond Premium?

A bond discount occurs when a bond is sold for less than its face value, whereas a bond premium happens when a bond is sold for more than its face value.

How does Bond Discount affect bond yield?

A bond purchased at a discount has a higher yield-to-maturity than the coupon rate, as the investor receives the par value at maturity which is higher than the price they initially paid.

Can the Bond Discount change over time?

Yes. As the remaining life of the bond decreases, the bond discount amortizes. Therefore, the value of the bond moves closer to its face value.

Is a Bond sold at a discount a bad investment?

Not necessarily. A bond sold at a discount can provide a higher yield compared to a bond sold at par or premium. However, it’s important to consider other factors such as the bond issuer’s risk level and overall interest rate environment.

Related Finance Terms

Sources for More Information


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