Introduction to Discount Bonds

When you start investing in bonds, you’ll often hear about discount bonds. These are bonds sold for less than their face value. Understanding discount bonds can help you spot good investment opportunities and make smarter choices.

In this article, we’ll explain what discount bonds are, how they work, and why investors find them attractive. You’ll also learn how to evaluate these bonds to fit your financial goals.

What Is a Discount Bond?

A discount bond is a bond that sells below its face (or par) value. For example, if a bond’s face value is $1,000 but you buy it for $950, that bond is a discount bond.

These bonds usually pay interest at a fixed rate, but the price you pay is less than what you’ll get back at maturity. The difference between the purchase price and the face value is your gain.

• Face Value:

  The amount paid back at maturity, usually $1,000.

• Discount Price:

  The price you pay, which is less than the face value.

• Yield:

  Your effective return, which can be higher than the coupon rate because of the discount.

Why Do Bonds Trade at a Discount?

Bonds trade at a discount for several reasons. The main cause is changes in interest rates. When market interest rates rise above a bond’s coupon rate, the bond’s price falls below face value.

Other reasons include:

• Credit Risk:

  If the issuer’s credit rating drops, investors demand a discount to compensate for higher risk.

• Market Conditions:

  Economic uncertainty or lower demand can push prices down.

• Time to Maturity:

  Bonds closer to maturity tend to trade near face value, while longer-term bonds may have bigger discounts.

How Do You Benefit from Discount Bonds?

Buying discount bonds can be profitable. Here’s how you benefit:

• Capital Gain:

  At maturity, you receive the full face value, which is more than your purchase price.

• Higher Yield:

  The yield to maturity (YTM) is higher than the coupon rate because you bought the bond cheaper.

• Income Stream:

  You still receive regular coupon payments based on the bond’s face value.

For example, if you buy a $1,000 bond for $900 with a 5% coupon, you earn $50 annually plus a $100 gain at maturity.

Types of Discount Bonds

Discount bonds come in different forms. Some common types include:

• Zero-Coupon Bonds:

  These bonds pay no interest but are sold at a deep discount. You earn all your return at maturity.

• Regular Coupon Bonds:

  Bonds with coupons can also trade at a discount if market rates rise.

• Callable Bonds:

  These may trade at a discount if there’s a risk the issuer will redeem early.

How to Evaluate Discount Bonds

Before investing, consider these factors:

• Yield to Maturity (YTM):

  This measures your total return if you hold the bond to maturity.

• Credit Quality:

  Check the issuer’s credit rating to assess default risk.

• Interest Rate Trends:

  Rising rates can push bond prices lower, affecting discounts.

• Time Horizon:

  Longer maturities may offer bigger discounts but come with more risk.

Risks of Investing in Discount Bonds

While discount bonds can be attractive, they carry risks:

• Interest Rate Risk:

  Prices can fall if rates rise further.

• Credit Risk:

  Issuer default can lead to loss of principal.

• Liquidity Risk:

  Some discount bonds may be harder to sell quickly.

Understanding these risks helps you decide if discount bonds fit your portfolio.

Conclusion

Discount bonds are a valuable tool in bond investing. They offer the chance to buy bonds below face value, potentially increasing your returns through capital gains and higher yields.

By understanding how discount bonds work, why they trade below par, and the risks involved, you can make informed investment decisions. Use this knowledge to diversify your portfolio and meet your financial goals.

What is the main difference between a discount bond and a premium bond?

A discount bond sells below its face value, while a premium bond sells above face value. Discount bonds offer higher yields due to the lower purchase price.

How does interest rate affect discount bonds?

When market interest rates rise above a bond’s coupon rate, the bond price falls below face value, creating a discount.

Can zero-coupon bonds be considered discount bonds?

Yes, zero-coupon bonds are sold at a deep discount and pay no periodic interest, providing returns only at maturity.

What risks should I watch for with discount bonds?

Key risks include interest rate risk, credit risk of the issuer, and liquidity risk when selling the bond before maturity.

How do I calculate the yield on a discount bond?

You calculate yield to maturity (YTM), which considers the purchase price, coupon payments, and the amount received at maturity.