What Is a Discount Note?

A discount note is a short-term debt obligation issued at a discount to par. Discount notes are similar to zero-coupon bonds and Treasury bills and are typically issued by government-sponsored agencies or highly rated corporate borrowers.

Discount notes have maturity dates of up to one year in length.

Discount Notes Explained

Discount notes are fixed income securities that do not make interest payments for the duration of the note. Since investors don’t get the added advantage of periodic interest income, the notes are offered at a discount to par. On the maturity date, the notes mature at a par value above the purchase price, and the price appreciation is used to calculate the investment's yield. For example, an investor that purchases a discount note for $9,400 will receive the par value of $10,000 when it matures 90 days from now. His return on the investment can be calculated as the difference between the purchase price and face value, that is, $10,000 - $9,400 = $600.

The price discount received by the bondholder at maturity can also be taken as the imputed interest earned on the bond. To calculate the effective rate earned on the bond, the interest earned can be divided by the product of the purchase value and time to maturity.

Effective rate = $600/[$9,400 x (90/360)]

Effective rate = 25.53%

Most institutional fixed-income buyers will compare the yield-to-maturity (YTM) of various zero-coupon debt offerings with standard coupon bonds, in order to find yield pickup in discount bonds.

The biggest issuers of discount notes are government-sponsored agencies, such as the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal Home Loan Bank (FHLB). These agencies issue notes to investors as a way to raise short-term capital for different projects. Discount notes issued by Freddie Mac, for example, have maturities that range from overnight to one year. The notes are issued and maintained in book-entry form through the Federal Reserve Bank of New York, and investors may acquire the notes in denominations as small as $1,000.

One of the advantages of discount notes is that they are not as volatile as other debt instruments. They are, therefore, perceived to be a safe investment for investors looking to preserve their capital in a low-risk investable security. In addition, these debt instruments are considered safe investments due to the fact that they are backed by the full faith and credit of the US government. Risk of default is, thus, minimal. The purchase of discount notes may also prove to be advantageous for investors who would need access to the funds after a short period of time.

For tax purposes, any gain made from the sale or redemption of the discount bond is treated as ordinary income up to the amount of the ratable share of the bond.