What Is a Discount Bond?

What Is a Discount Bond?

Let me tell you directly: a discount bond is a security that's issued for less than its par or face value. It could also be one that trades below face value in the secondary market. If it's sold at a price that's 20% or more below par, we call it a deep-discount bond. This is the opposite of a bond sold at a premium.

Key Takeaways

You need to remember that a discount bond is issued or traded below its par value. When a distressed bond trades at a big discount, it can push its yield up to appealing levels. Often, these bonds suggest that the issuing company might default on its debt.

Understanding Discount Bonds

Bonds are fixed-income securities issued by governments or companies to raise funds. The issuer owes money to the bondholder, who acts as the creditor. The face value is what you pay for the bond—say, $1,000 for a $1,000 face value bond. As a bondholder, you get interest payments, known as coupons, typically semiannually, though they can be monthly, quarterly, or annually. At maturity, you expect the full face value back.

Some bonds trade below this value, and those are discount bonds. For instance, a $1,000 face value bond selling for $95 is discounted. Both big institutions and individual investors like you can buy and sell them, but institutions have specific rules to follow. A classic example is a U.S. savings bond.

Fast Fact

You can convert old bond prices to current market value using yield to maturity (YTM). This calculation factors in the bond's market price, par value, coupon rate, and time to maturity to find its return. It's complex, but online calculators make it straightforward.

Special Considerations

Some bonds have deep discounts, like distressed ones with a high default risk. They trade way below par, boosting yields, but they often skip full or timely interest payments. Buying them is speculative. Zero-coupon bonds are another deep discount type—they might be issued at 20% or more below par, depending on maturity. They pay no periodic interest, just the face value at maturity, so their price rises steadily toward that date, assuming no defaults.

Advantages and Disadvantages of Discount Bonds

Discount bonds carry risks and rewards, just like any discounted item. On the plus side, buying below face value opens up bigger capital gains potential, though you'll owe taxes on those gains. They come in short- and long-term maturities, letting you diversify risks. You usually get regular interest, except with zero-coupon bonds, which pay nothing until maturity.

On the downside, check the issuer's creditworthiness carefully. There's a real chance of default on the principal, falling dividends, or buyers shying away. This is especially true for long-term bonds from financially troubled companies.

Discount Bonds and Interest Rates

Bond yields and prices move inversely with interest rates. If rates rise, bond prices fall, and vice versa. A bond with a coupon rate below current market rates will sell below face value because buyers can get better returns elsewhere. If you buy a bond and rates go up, its value drops, forcing you to sell at a discount if you want out. But that discount doesn't mean a better yield—it offsets the bond's lower rate compared to the market. For example, a $1,000 par bond at $980 has a coupon lower than prevailing yields. If rates fall below the coupon, the bond trades at a premium.

Discount Bonds and Default Risk

Discount bonds have a good shot at appreciating if the issuer doesn't default—you get the full face value at maturity despite paying less. Maturities range from short-term (under a year) to long-term (10-15 years or more). But longer terms increase default odds, often signaling the issuer's financial distress. Discounts can reflect expected defaults, dividend cuts, or investor hesitation, so you're compensated with the lower price for taking that risk.

Example of a Discount Bond

Consider Company ABC offering a discount bond with a 4.915% coupon rate, maturing on 08/01/2034, yielding 4.92% at $100 offering price, with fixed coupons. Now it trades at $79.943, while the 10-year Treasury yields 2.45%—making this bond's yield attractive. But the company's recent troubles make it risky, trading at a discount despite a higher coupon than Treasuries. Yields have spiked to 7% some days, showing it's deeply discounted with a yield far above the coupon and price well below par.

What Is a Distressed Bond?

A distressed bond comes from a company in financial trouble, possibly nearing bankruptcy. It trades at a steep discount and carries huge risk because the issuer might not meet obligations.

How Do Zero-Coupon Bonds Work?

Zero-coupon bonds are deeply discounted and pay no interest. You buy them cheap, say $850 for a $1,000 face value, and get the full amount at maturity, like in a year. Some issuers start with them, others convert if finances worsen.

Why Would Anyone Want a Discount Bond?

Discount bonds are fixed-income options sold below face value, promising high returns. You pay less but might get the full value at maturity. They're often from struggling companies, so risk is high, but some investors see value in that.

The Bottom Line

Bonds are generally low-risk, with promised face value and coupons. But discount bonds up the risk—they offer higher returns but might not pay out if the issuer fails before maturity. Do your homework before diving in.