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What is a 'Discount Bond'

A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the secondary market. A bond is considered a discount bond when it has a lower interest rate than the current market rate, and consequently is sold at a lower price. This interest rate, also called a coupon, is usually paid semiannually. As interest rates go up, bond prices go down. Discount bonds are similar to zero-coupon bonds, which are also sold at a discount, but the difference is that they don't pay interest. A common example of a discount bond is a U.S. savings bond.

A deep-discount bond is sold at a significantly lower price than par value, usually 20% or more.

BREAKING DOWN 'Discount Bond'

Discount bonds can be bought and sold by both businesses and individuals. Businesses have strict regulations for the selling and purchasing of discount bonds; they must keep detailed expense records of the discount bonds bought and sold on a balance sheet.

The "discount" in a discount bond doesn't necessarily mean that investors get a better yield than the market is offering, just a price below par. Depending on the length of time until maturity, zero-coupon bonds can be issued at very large discounts to par, sometimes 50% or more. A coupon, in the context of bonds, refers to the interest payments made. The frequency at which these coupons must be paid doesn't change; however, the amount of interest does, depending on market factors. Selling a bond before it's mature can result in either a gain or a loss.

Often, a bond purchased in the past is either discounted or sold as a premium bond when it enters the current market, in order to balance it out with other bonds that are being sold. A discount bond is the opposite of a premium bond, which occurs when the market price of a bond is higher than the price for which it was originally sold. To compare the two in the current market, and to convert older bond prices to their value in the current market, you can use a calculation called yield to maturity. Yield to maturity considers the bond's current market price, par value, coupon interest rate, and time to maturity in order to calculate a bond's return.

Examples of Discount Bonds

Let's say you bought a bond a few years ago, but now you want to sell it. The value of your bond will most likely be different, since the market is constantly fluctuating. Let's say that interest rates have risen from 5% when you originally purchased the bond, to 10%. A potential investor will insist that you match this new 10% interest rate before purchasing the bond at face value. Alternatively, you could sell your bond for a lower price originally, so that the difference matches the amount of projected interest, and not have to worry about making interest payments at all. The amount of this projected interest will match the amount of your annual coupon, totaled over all years of payment. For example, if your coupon is for $20 and your bond has five years until maturity, the total interest will be $100, and an investor can pay that much less for the bond initially, rather than receiving coupons. Either way, in this situation, you hold a discount bond, since interest rates have gone up and consequently, the price is below the current market value.

Let's take another example, to show a bit of what a business needs to do when selling a discount bond. In this situation, the bond seller is a business that originally purchased the bond for $10,000 but is now selling it at $9,000 due to rising interest rates. On the balance sheet, the business would need to record the current value of the bond, $9,000, and the amount of the discount, $1,000, to calculate the "Bond Payable" field, $10,000. The business would also need to amortize the amount, or pay it off in fixed installments over a set time frame. Amortization works much like depreciation, in that it reduces the discount amount over time, so that when the bond matures, the bond's carrying amount matches its face value. At this point, the business pays off the face value.

Pros and Cons of Purchasing a Discount Bond

If you buy a discount bond, the chances of seeing the bond appreciate in value are fairly high, as long as the lender doesn't default. If you hold out until the bond is mature, you'll be paid the face value of the bond, even though what you originally paid was less than face value. Maturity rates vary between short-term and long-term; short-term bonds are usually called bills, and they mature in less than a year, while long-term bonds mature over ten to fifteen years, or even longer.

However, the chances of default might be higher, as a discount bond can indicate that the lender is in a less than ideal place in the market or will likely be in the future. This article specifically discusses both the causes and effects of discount bonds, comparing 2015 rates with those from the 2008 financial crisis and showing the relationship between interest rates and discount bonds. The presence of discount bonds can indicate many things, such as predictions of falling dividends or a reluctance to buy on the part of the investors.

Because a bond will always pay its full face value at maturity (assuming no credit events occur), discount bonds issued below par – such as zero-coupon bonds – will steadily rise in price as the maturity date approaches. These bonds will only make one payment to the holder (par value at maturity) as opposed to periodic interest payments.

A distressed bond (one that has a high likelihood of default) can also trade for huge discounts to par, effectively raising its yield to very attractive levels. The consensus, however, is that these bonds will not receive full or timely interest payments at all; because of this, investors who buy into these issues become very speculative, possibly even making a play for the company's assets or equity.

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