What Is the Discount Yield?
Let me explain the discount yield directly: it's a method for calculating a bond's return when you buy it at a discount to its face value, and we express it as a percentage. You'll see this commonly used for municipal notes, commercial paper, and treasury bills that are sold at a discount.
Key Takeaways
- Discount yield computes the expected return of a bond you purchase at a discount and hold until maturity.
- Discount yield is computed using a standardized 30-day month and 360-day year.
- This calculation is commonly used for evaluating Treasury bills and zero-coupon bonds.
The Formula for Discount Yield
The formula for discount yield uses a 30-day month and 360-day year to keep things straightforward. You calculate it as the discount divided by the face value, multiplied by 360 divided by the days to maturity. I've seen this represented in various financial resources, and it's essential for consistency in short-term investments.
Understanding the Discount Yield
When you invest in a discount bond, the discount yield tells you your return on investment if you hold it until maturity. Think of Treasury bills issued below par value, or commercial paper and municipal notes—these are short-term debts from municipalities. U.S. Treasury bills max out at six months, unlike longer-term notes and bonds.
If you sell the security before maturity, your return changes based on the sale price. For instance, if you buy a $1,000 corporate bond for $920 and sell it for $1,100 after five years, you need to account for the discount posted to income and calculate the gain accordingly.
Zero-coupon bonds are another clear example of discount bonds. Depending on maturity, they can be issued at deep discounts, say 20% or more below par. These bonds don't pay periodic interest; they just return the full face value at maturity, assuming no defaults, so their price rises steadily toward that date.
Example
Consider this scenario: you purchase a $10,000 Treasury bill at a $300 discount, so you pay $9,700, and it matures in 120 days. The discount yield here is ($300 / $10,000) * (360 / 120), which comes out to a 9% yield. This shows you exactly how the calculation works in practice.
The Differences Between Discount Yield and Accretion
Discount yield is specifically for securities sold at a discount to figure your rate of return, but it's not the same as bond accretion. Bonds using accretion might be issued at par, discount, or premium, and accretion spreads that discount into your bond income over the bond's life.
Take an investor buying a $1,000 corporate bond for $920 with 10 years to maturity. The $80 discount becomes bond income, plus any interest. You can use straight-line accretion for equal annual amounts or the effective interest rate method for a more precise calculation. This approach ensures the income is recognized properly over time.
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