What is a 'Discount'

In finance, discount refers to a situation when a bond is trading for lower than its par or face value. The discount equals the difference between the price paid for a security and the security's par value.

BREAKING DOWN 'Discount'

For example, if a bond with a par value of $1,000 is currently selling for $990 dollars, it is selling at a discount of ($1000/$990) - 1 = 1%, or $10. The reason a bond will trade at a discount is if it has a lower interest or coupon rate than the prevailing interest rate in the economy. In other words, since the issuer is not paying as high of an interest rate to the bondholder, the bond must be sold at a lower price to be competitive, or else no one would buy it. This interest rate, known as a coupon, is generally paid on a semiannual basis. The term coupon comes from the days of physical bond certificates (as opposed to electronic ones), when some bonds had coupons attached to them. Some examples of bonds that trade at a discount include U.S. savings bonds and Treasury bills.

Stocks and other securities can similarly be sold at a discount. However, this discount is not due to interest rates; rather, a discount is usually implemented in the stock market in order to generate buzz around a particular stock. In addition, the par value of a stock only specifies the minimum price the security can be sold for upon its initial entrance into the market.

Deep Discounts and Pure Discount Instruments

A type of discount bond is a pure discount instrument. This bond or security pays nothing until maturity. This type of bond is sold at a discount, but when it reaches maturity, it pays the par value. For example, if you purchase a pure discount instrument for $900 and the par value is $1,000, you'll get $1,000 when the bond reaches maturity. Investors don't receive interest income from holding these securities, however, their return on investment is measured by the price appreciation of the bond. The more discounted the bond at the time of purchase, the higher the investor's rate of return at time of maturity.

One type of pure discount bond is a zero-coupon bond, which doesn't pay interest but instead is sold at a deep discount. The discount amount is equal to the amount lost by a lack of interest payments. Zero-coupon bond prices tend to fluctuate more often than bonds with coupons.

A deep discount doesn't only apply to zero-coupon bonds; it is generally considered to apply to any bond that is trading for 20% below market value and beyond.

Discounts vs. Premiums

A discount is the opposite of a premium, which applies when a bond is sold for higher than par value. A premium occurs if the bond is sold at, for example, $1,100 instead of its par value of $1,000. Conversely to a discount, a premium occurs when the bond has a higher interest rate than the current market rate.

RELATED TERMS
  1. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  2. Discount Yield

    Discount yield is a measure of a bond's percentage return, frequently ...
  3. Discounting

    Discounting is the process of determining the present value of ...
  4. Discount Note

    A discount note is a short-term debt obligation issued at a discount ...
  5. Bond Valuation

    Bond valuation is a technique for determining the theoretical ...
  6. Below Par

    Below par is a term describing a bond whose market price is below ...
Related Articles
  1. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  2. Investing

    Why Bond Prices Fall When Interest Rates Rise

    Never invest in something you don’t understand. Bonds are no exception.
  3. Investing

    Simple Math for Fixed-Coupon Corporate Bonds

    A guide to help to understand the simple math behind fixed-coupon corporate bonds.
  4. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  5. Investing

    Comparing Yield To Maturity And The Coupon Rate

    Investors base investing decisions and strategies on yield to maturity more so than coupon rates.
RELATED FAQS
  1. How can I calculate the carrying value of a bond?

    Learn what the carrying value of a bond means, how it can change, and the easiest way to calculate a bond's carrying value ... Read Answer >>
  2. How do debit spreads impact the trading of options?

    Find out what it means when a bond has a coupon rate of zero and how a bond's coupon rate and par value affect its selling ... Read Answer >>
  3. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
Hot Definitions
  1. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  2. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  3. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  4. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  5. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  6. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
Trading Center