What Is a Discount
In finance and investing, 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. Bonds are usually fixed-income, debt securities used when a business is raising funds for a project or expansion. Bonds may trade at a discount due to problems with the underlying company or the product offering a lower interest rate or terms than other, comparable bonds.
Understanding Par Value Discounts
The par value of a bond is most often set at $100 or $1000. This represents the lowest amount an investor may submit to invest in the product. The bond's par value is, generally, the same thing as face value is on a particular stock. The par value indicates what the issuer will repay to an investor when the debt security matures.
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. Since the issuer is not paying as high of an interest rate to the bondholder, the debt 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. However, there are bonds that pay a coupon yearly, monthly, and some that pay on redemption.
For example, if a bond with a par value of $1,000 is currently selling for $990, it is selling at a discount of 1% or $10 ($1000/$990 = 1).
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. Instead, 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
One type of discount bond is a pure discount instrument. This bond or security pays nothing until maturity. The bond is sold at a discount, but when it reaches maturity, it pays the bondholder the full par value. For example, if you purchase a pure discount instrument for $900 and the par value is $1,000, you will receive $1,000 when the bond reaches maturity.
Investors don't receive regular interest income payments from pure discount bonds. 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 the time of maturity.
An example of a 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.
The term deep discount doesn't only apply to zero-coupon bonds. It can be applied to any bond that is trading at 20% or more below market value.
Discounts vs. Premiums
A discount is the opposite of a premium. When a bond is sold for more than the par value, it sells at a premium. 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 than market interest rate or better company history.