Bond Discount

Definition

Bond Discount refers to the situation where a bond is sold for less than its face (or maturity) value. The difference between the bond’s market price and its higher face value constitutes the bond discount. A bond may be issued at a discount, or a discount may arise due to an increase in general interest rates or perceived risk of default. The discount is gradually realized as income by the bondholder, along with periodic interest payments, as the bond approaches maturity.

Examples

Issued at a Discount: A corporation issues a $1,000 face value bond for $950. The bond is sold at a $50 discount.
Market Conditions: An existing $1,000 face value bond trades in the market at $920 due to rising interest rates. The bondholder realizes an $80 discount at maturity.
Zero Coupon Bond: A zero coupon bond with a face value of $1,000 is sold for $700 because it pays no periodic interest. The bond discount of $300 is the income realized by the bond holder upon maturity.

Frequently Asked Questions (FAQs)

Q1: Why do bonds sell at a discount? A1: Bonds sell at a discount typically due to rising interest rates that make existing bonds with lower rates less attractive or because of perceived increased risk of default from the issuer.

Q2: How does a bond discount affect yield? A2: A bond discount increases the effective yield of the bond because the investor earns not only the regular interest payments but also the amount of the discount upon maturity.

Q3: What is the difference between a bond discount and a bond premium? A3: A bond discount occurs when a bond sells for less than its face value, whereas a bond premium occurs when a bond sells for more than its face value.

Q4: How is the bond discount recorded in accounting? A4: The bond discount is amortized over the life of the bond using methods like the straight-line method or the effective interest rate method, and this amortization is recorded as an increase in interest expense.

Q5: Are zero coupon bonds always issued at a discount? A5: Yes, zero coupon bonds are always issued at a discount because they do not provide periodic interest payments and the investor’s return is the difference between the purchase price and the maturity value.

Face Value: The nominal or dollar value of a bond that is paid to the bondholder at maturity.
Zero Coupon Bond: A bond that is issued at a significant discount from its face value and does not make regular interest payments but rather pays the full face value at maturity.
Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures, including interest payments and amortization of any premium or discount.
Interest Rate Risk: The risk that changes in interest rates will affect the value of bonds, causing them to trade at a discount or premium.

Online References

Suggested Books for Further Studies

“The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More” by Annette Thau.
“Bonds: An Introduction to the Core Concepts” by Mark Mobius.
“Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi.
“Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman.

Fundamentals of Bond Discount: Finance Basics Quiz

### What is the bond discount? - [ ] The amount above the face value at which a bond is sold. - [x] The difference between the bond's market price and its face value when sold below face value. - [ ] The regular interest payments received from a bond. - [ ] Fees associated with buying a bond. > **Explanation:** The bond discount is the difference between a bond's current market price and its higher face value when sold below the face value. ### What kind of bond is typically issued at a significant discount? - [ ] Regular coupon bond - [x] Zero coupon bond - [ ] Convertible bond - [ ] Floating rate bond > **Explanation:** A zero coupon bond is typically issued at a significant discount because it does not provide periodic interest payments and its return is derived entirely from the price difference. ### How does rising interest rates impact the price of existing bonds? - [x] Existing bond prices decrease. - [ ] Existing bond prices remain the same. - [ ] Existing bond prices increase. - [ ] Existing bonds are reissued. > **Explanation:** Rising interest rates make existing bonds with lower interest rates less attractive, causing their prices to decrease. ### What is the primary reason for a bond discount to exist in the market? - [ ] High demand for the bond - [x] Rising interest rates or increased risk of default - [ ] The bond has reached its maturity date - [ ] Issuer’s profit margin > **Explanation:** A bond discount exists in the market primarily due to rising interest rates or increased risk of default, which makes the bond less attractive compared to new issues. ### How do bond holders realize the bond discount? - [ ] By selling the bond before maturity - [ ] By recouping the discount through periodic interest payments - [x] By receiving the difference between the purchase price and face value at maturity - [ ] Immediately after purchase > **Explanation:** Bondholders realize the bond discount by receiving the difference between the purchase price and face value at maturity. ### What is the amortization of bond discount? - [ ] Payment of lump sum at the end. - [x] Gradual recognition of the bond discount as interest expense over the life of the bond. - [ ] Immediate deduction from issuer’s profit. - [ ] Conversion of bonds to equities. > **Explanation:** The amortization of bond discount refers to the gradual recognition of the bond discount as interest expense over the bond's life. ### How does a bond discount affect the yield to maturity? - [ ] It decreases the yield. - [ ] It has no effect on the yield. - [x] It increases the yield. - [ ] It quadruples the yield. > **Explanation:** A bond discount increases the yield to maturity as the income from the bond includes both interest payments and the realized discount. ### What determines if a bond is selling at a discount? - [ ] If its market price is higher than its face value - [ ] If its market price is equal to its face value - [x] If its market price is lower than its face value - [ ] If its market price fluctuates constantly > **Explanation:** A bond sells at a discount if its market price is lower than its face value. ### Why might an investor prefer purchasing a bond at a discount? - [ ] They enjoy the challenge. - [ ] They prefer newer issues. - [x] To benefit from potential capital appreciation upon bond maturity. - [ ] They avoid all types of risk. > **Explanation:** An investor may prefer purchasing a bond at a discount to benefit from potential capital appreciation upon bond maturity. ### What methodology is used to amortize the bond discount? - [ ] Direct method - [x] Straight-line method or effective interest rate method - [ ] Declining balance method - [ ] Hours worked method > **Explanation:** The bond discount is typically amortized using the straight-line method or the effective interest rate method, spreading out the discount over the life of the bond.

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