DEFINITION of Bank Discount Basis
Bank discount basis, also known as discount yield, is a convention used by financial institutions when quoting prices for fixed-income securities sold at a discount, such as municipal and U.S. Treasury bills. The quote is presented as a percentage of face value, and is determined by discounting the bond by using a 360-day-count convention, which assumes there are twelve 30-day months in a year.
BREAKING DOWN Bank Discount Basis
The bank discount basis shows as an annualized yield, stated as a percentage. It is the return on investment generated by purchasing the investment at a discount and then selling it par when the bond matures. Treasury bills, along with many forms of corporate commercial paper and municipal notes, are issued at a discount from par value — the face value. U.S. Treasury bills have a maximum maturity of six months (26 weeks), while Treasury notes and bonds have longer maturity dates.
While the 30/360 day-count convention is the standard banks use when quoting government treasury bonds, the bank discount rate will be lower than the actual yield you receive on your short-term money market investment – because there are 365 days in a year. The rate should, therefore, not be used as an exact measurement of the yield that will be received. Over longer maturities, the day count convention will have a greater impact on the current 'price' of a bond than if the time to maturity is much shorter.
To convert a 360-day yield to a 365-day yield, simply "gross up" the 360-day yield by the factor 365/360. A 360-day yield of 8% would equate to an 8.11% yield based on a 365-day year.
8% * (365 / 360) = 8.11%
For more on comparing bond yields, read How to compare the yields of different bonds.
How To Calculate The Bank Discount Rate
The bank discount basis, or bank discount rate, is calculated using the following formula:
Bank discount rate = (Discount from par value / par value) * (360 / days to maturity)
= ((par value – purchase price) / par value) * (360 / days to maturity)
Assume, for example, that an investor purchases a $10,000 Treasury bill at a $300 discount from par value (a price of $9,700), and that the security matures in 120 days. In this case, the discount yield is ($300 discount)[/$10,000 par value] * 360/120 days to maturity, or a 9% yield.
The Differences Between Discount Yield and Accretion
Securities that are sold at a discount use the discount yield to calculate the investor's rate of return, and this method is different than bond accretion. Bonds that use bond accretion can be issued a par value, at a discount or at a premium, and accretion is used to move the discount amount into bond income over the remaining life of the bond.
Assume, for example, that an investor purchases a $1,000 corporate bond for $920, and the bond matures in 10 years. Since the investor receives $1,000 at maturity, the $80 discount is bond income to the owner, along with the interest earned on the bond. Bond accretion means that the $80 discount is posted to bond income over the 10-year life, and an investor can use a straight-line method or the effective interest rate method. Straight-line posts the same dollar amount into bond income each year, and the effective interest rate method uses a more complex formula to calculate the bond income amount. Bonds with a coupon can also be quoted at on a yield basis.