Discount bond

Definition

A discount bond is a type of bond that is sold for less than its face value, meaning investors purchase it at a lower price than what they will receive at maturity. This occurs because the bond does not pay interest periodically, or its coupon rate is lower than current market interest rates. The difference between the purchase price and the face value is what investors earn as their return when the bond matures.

5 Must Know Facts For Your Next Test

1. Discount bonds do not pay periodic interest payments, which makes them appealing during periods of rising interest rates since they offer a potential capital gain upon maturity.
2. When calculating the yield to maturity for a discount bond, the entire difference between the purchase price and the face value contributes to the investor's overall return.
3. Zero-coupon bonds are a common example of discount bonds, as they are sold at a significant discount and do not provide periodic interest payments.
4. The market price of a discount bond typically increases as it approaches its maturity date, reflecting its face value at maturity.
5. Investors in discount bonds should consider factors such as interest rate risk and credit risk, as these can affect the bond's market price and overall return.

Review Questions

• How does the price of a discount bond relate to market interest rates?
  • The price of a discount bond is inversely related to market interest rates. When market interest rates rise, existing bonds with lower coupon rates become less attractive, leading to a decrease in their market price. Conversely, if interest rates fall, existing discount bonds may increase in value as their fixed returns become more appealing compared to newly issued bonds with lower yields.
• Evaluate how an investor might benefit from purchasing a discount bond compared to a standard coupon bond.
  • An investor might benefit from purchasing a discount bond because it offers the potential for capital gains upon maturity, where they receive the full face value. Additionally, discount bonds may be more appealing during rising interest rate environments since they are sold at lower prices, allowing investors to enter the market at a more favorable entry point. However, investors must weigh this against the lack of periodic income from coupon payments that standard bonds provide.
• Assess the implications of investing in discount bonds for an investor's overall portfolio strategy in varying interest rate environments.
  • Investing in discount bonds can significantly influence an investor's portfolio strategy depending on prevailing interest rate conditions. In an environment of rising interest rates, discount bonds could be advantageous as they offer capital appreciation potential without immediate cash flows from interest payments. However, in declining rate environments, these bonds may become less appealing compared to standard coupon bonds that offer regular income. Therefore, strategic allocation between discount and coupon bonds should align with an investor's expectations about future interest rates and their income needs.

Related terms

Face Value: The amount of money a bondholder will receive from the issuer at maturity, also known as par value.

Yield to Maturity (YTM): The total return expected on a bond if it is held until maturity, taking into account both interest payments and capital gains or losses.

Coupon Rate: The annual interest rate paid on a bond's face value, expressed as a percentage.