Discount bond

Definition

A discount bond is a type of debt security that is sold for less than its face value, or par value, and pays no interest during its life. Instead, the investor earns a return when the bond matures, receiving the full face value. This feature connects it to the broader category of fixed income securities, as it represents a way for investors to generate income through capital appreciation rather than periodic interest payments.

5 Must Know Facts For Your Next Test

1. Discount bonds do not provide regular coupon payments like traditional bonds; instead, investors gain profit when they receive the full face value at maturity.
2. The price of a discount bond is always below its par value, which creates an inherent capital gain when it matures.
3. These bonds are typically used by investors looking for a lower entry price and are particularly appealing in environments where interest rates are low.
4. Discount bonds can be issued by various entities, including governments and corporations, making them accessible to a wide range of investors.
5. Tax implications can vary for discount bonds; in some jurisdictions, the difference between the purchase price and face value may be considered taxable income upon maturity.

Review Questions

• How do discount bonds differ from traditional coupon-paying bonds in terms of cash flow for investors?
  • Discount bonds differ from traditional coupon-paying bonds primarily in their cash flow structure. While coupon bonds provide regular interest payments throughout their life, discount bonds offer no periodic interest. Instead, investors realize their returns only when the bond matures and they receive the full face value. This means that discount bonds require patience and a longer-term investment perspective compared to their coupon-paying counterparts.
• What factors might lead an investor to choose a discount bond over other types of fixed income securities?
  • An investor might choose a discount bond for several reasons, such as a lower purchase price relative to its face value and potential for capital appreciation at maturity. Additionally, in a low-interest-rate environment where traditional coupon rates are minimal, discount bonds can offer a more attractive yield by allowing investors to benefit from buying at a lower initial cost. Furthermore, they may appeal to investors seeking tax advantages if the accrued interest on discount bonds is taxed differently than regular coupon payments.
• Evaluate the risks associated with investing in discount bonds and how they compare to other fixed income securities.
  • Investing in discount bonds carries specific risks that investors should consider. One primary risk is interest rate risk; if rates rise after purchasing a discount bond, its market value may decline before maturity. Additionally, there’s credit risk if the issuer defaults, leading to potential losses. Compared to other fixed income securities like traditional coupon bonds or government bonds, discount bonds can be more volatile due to their price sensitivity and lack of periodic interest payments. Therefore, understanding these risks is essential for investors seeking to incorporate discount bonds into their portfolios.

Related terms

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

Zero-Coupon Bond: A bond that does not pay periodic interest and is issued at a discount, with its return based solely on the difference between the purchase price and the face value at maturity.

Yield to Maturity:

The total return anticipated on a bond if held until it matures, taking into account both interest payments and any capital gains or losses.