Discount bond

Definition

A discount bond is a type of debt security that is sold for less than its face value, meaning it does not pay periodic interest payments but instead provides a return to the investor by being redeemed at full face value upon maturity. This type of bond is especially relevant in understanding how interest rates affect bond pricing and investor returns, as the difference between the purchase price and the face value represents the investor's yield. The concept of a discount bond ties closely to bond risk and return, as the price fluctuations in response to changes in market interest rates can significantly impact an investor's overall returns.

5 Must Know Facts For Your Next Test

1. Discount bonds are often issued by governments or corporations, allowing them to raise capital without paying periodic interest, which can be beneficial for cash flow management.
2. The amount by which a discount bond is sold below its face value reflects the current market interest rates; as rates increase, discount bonds may become cheaper.
3. Investors in discount bonds receive their return solely from the appreciation of the bond as it moves towards its face value at maturity.
4. These bonds can be more sensitive to interest rate changes compared to coupon bonds, making them potentially riskier in volatile markets.
5. Discount bonds are commonly associated with zero-coupon bonds, which are sold at a steep discount and pay no interest until maturity.

Review Questions

• How does purchasing a discount bond differ from buying a traditional coupon bond in terms of cash flows?
  • Purchasing a discount bond means that an investor does not receive periodic interest payments like they would with a traditional coupon bond. Instead, they buy the bond at a price lower than its face value and receive only the face value upon maturity. This results in their entire return coming from the appreciation in value over time rather than regular cash flows during the bond's life.
• What factors contribute to the price fluctuation of discount bonds in relation to market interest rates?
  • The price of discount bonds fluctuates mainly due to changes in market interest rates. When market rates rise, existing bonds become less attractive, leading to a decrease in their prices. Conversely, if rates fall, discount bonds become more appealing because they can offer higher relative yields when redeemed at face value. This inverse relationship creates significant interest rate risk for investors holding discount bonds.
• Evaluate the risks and benefits associated with investing in discount bonds compared to other fixed-income securities.
  • Investing in discount bonds comes with unique risks and benefits. One significant benefit is that they can offer substantial returns if held until maturity, particularly when purchased at low prices during periods of high interest rates. However, they also carry higher sensitivity to interest rate changes, resulting in greater price volatility compared to other fixed-income securities like coupon bonds. Investors must weigh these aspects carefully when considering their investment strategy, especially in fluctuating economic conditions where interest rates may vary widely.

Related terms

face value: The nominal value of a bond that is paid back to the bondholder at maturity.

yield to maturity:

The total return anticipated on a bond if it is held until it matures, taking into account the purchase price, face value, and time to maturity.

interest rate risk:

The risk that changes in market interest rates will adversely affect the price of a bond.