Definition
A discount bond is a type of bond that is sold to investors at a price lower than its face value or par value. The face value is the amount paid back to the bondholder at maturity. For instance, an investor may purchase a bond with a face value of $1,000 for $950. When the bond matures, the investor receives the full $1,000, earning a profit of $50.
Examples
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Treasury Bills (T-Bills): These are short-term government securities sold at a discount from the face value. For example, a $10,000 T-Bill might be sold for $9,800, and the investor will receive $10,000 at maturity.
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Zero Coupon Bonds: These bonds do not pay periodic interest and are sold at a deep discount, accruing interest that compounds to be paid at maturity. For example, a $5,000 zero-coupon bond might be sold for $3,500.
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Corporate Bonds: A company might issue a $1,000 face value bond at a discount for $970 to incentivize investors when market interest rates are higher than the bond’s coupon rate.
Frequently Asked Questions
Q1: Why do companies issue discount bonds?
A1: Companies issue discount bonds to attract investors when market interest rates are higher than the bond’s coupon rate or to raise capital quickly.
Q2: How do investors profit from discount bonds?
A2: Investors profit by buying the bond at a price below its face value and receiving the face value at maturity, or through price appreciation if the bond is sold before maturity.
Q3: What are the risks associated with discount bonds?
A3: Risks include interest rate risk, where rising rates can decrease bond prices, and default risk, where the issuer might fail to pay back the face value.
Q4: Are taxes applicable on the profits from discount bonds?
A4: Yes, the profit made from the difference between the purchase price and the face value is typically subject to capital gains tax, and specific rules depend on the jurisdiction.
Q5: Can discount bonds be bought and sold in the secondary market?
A5: Yes, discount bonds can be traded on the secondary market, where their prices may fluctuate based on interest rates and market demand.
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Bond Discount: The difference between a bond’s face value and its selling price when sold for less than face value.
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Zero Coupon Bond: A bond sold at a deep discount that doesn’t pay periodic interest, instead providing its return at maturity.
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Face Value (Par Value): The amount paid to the bondholder at maturity.
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Yield to Maturity (YTM): The total return anticipated on a bond if held until it matures.
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Coupon Rate: The annual interest rate paid on a bond’s face value.
Recommended Online Resources
- Investopedia: Discount Bond
- U.S. Securities and Exchange Commission
- Bloomberg Markets
- Federal Reserve Bank
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
- “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi
- “Fixed Income Analysis” by Barbara S. Petitt and Jerald E. Pinto
Fundamentals of Discount Bonds: Finance Basics Quiz
### What is a discount bond?
- [ ] A bond sold at higher than face value.
- [x] A bond sold for less than its face value.
- [ ] A bond sold at exactly face value.
- [ ] A bond that pays dividends.
> **Explanation:** A discount bond is a bond that is sold for less than its face value. When it matures, the investor receives the face value, making a profit.
### Why might an issuer sell a bond at a discount?
- [x] To make the bond more attractive in a high-interest-rate environment.
- [ ] To sell bonds quickly in a low-interest-rate environment.
- [ ] Because the issuer is confident about the financial market conditions.
- [ ] Issuers do not typically sell bonds at a discount.
> **Explanation:** Issuers sell bonds at a discount to make them more attractive to investors when prevailing market interest rates are higher than the bond's coupon rate.
### What is the benefit of buying a zero-coupon bond?
- [ ] Periodic interest payments.
- [x] They are purchased at a deep discount and mature at face value.
- [ ] Immediate liquidity.
- [ ] Higher annual coupon rates.
> **Explanation:** The primary benefit of zero-coupon bonds is that they are purchased at a deep discount and provide the full face value at maturity, representing the interest earned.
### What is a typical investment risk associated with discount bonds?
- [x] Interest rate risk.
- [ ] Lack of marketable options.
- [ ] No maturity value.
- [ ] No tax implications.
> **Explanation:** Discount bonds are subject to interest rate risk, where rising interest rates can decrease the bond's price.
### What happens to the face value of a discount bond upon maturity?
- [ ] It remains the same as the selling price.
- [ ] It depreciates further.
- [x] It's paid out in full to the bondholder.
- [ ] It's split among multiple investors.
> **Explanation:** Upon maturity, the face value of a discount bond is paid out in full to the bondholder, which is typically more than the purchase price.
### What type of bond sells at a price significantly lower than its face value but does not make periodic interest payments?
- [ ] Treasury Bond.
- [ ] Municipal Bond.
- [x] Zero Coupon Bond.
- [ ] Corporate Bond paying coupons.
> **Explanation:** A zero-coupon bond is sold at a price significantly lower than its face value and does not make periodic interest payments.
### The difference between the bond's face value and its selling price is known as:
- [x] Bond Discount.
- [ ] Coupon Rate.
- [ ] Yield.
- [ ] Market Price.
> **Explanation:** The bond discount is the difference between the bond's face value and its selling price when it is sold for less than its face value.
### In the context of bonds, what is meant by 'par value'?
- [ ] The current market price of the bond.
- [ ] The interest rate offered by the bond.
- [x] The face value of the bond.
- [ ] The bond's annual return rate.
> **Explanation:** Par value or face value is the amount the bondholder receives at maturity, typically the stated value of the bond.
### Which entity can issue discount bonds?
- [ ] Only government bodies.
- [x] Governments, corporations, and municipalities.
- [ ] Sole proprietors.
- [ ] Only municipal bodies.
> **Explanation:** Governments, corporations, and municipalities can all issue discount bonds to raise capital.
### What influences the price of a discount bond in the secondary market?
- [ ] The coupon rate.
- [x] Prevailing interest rates and market demand.
- [ ] The initial purchase price.
- [ ] The bond's age relative to maturity.
> **Explanation:** The price of a discount bond in the secondary market is influenced by prevailing interest rates and market demand.
