Key Takeaways
- Measures annualized return on discount securities.
- Uses face value and 360-day year for calculation.
- Typically understates yield compared to other methods.
- Common for short-term, no-coupon instruments like T-bills.
What is Discount Yield?
Discount yield measures the annualized return on discount securities like Treasury bills and zero-coupon bonds, calculated by comparing the discount to the face value using a 360-day year convention. It provides a standardized way to quote yields on short-term instruments without coupons.
This yield is often used in money markets to evaluate investments priced below their face value, reflecting the investor's return if held to maturity.
Key Characteristics
Discount yield has distinct features that differentiate it from other yield measures:
- Face value basis: It uses the face value as the denominator, which tends to understate returns compared to yields based on purchase price.
- 360-day year convention: The calculation annualizes returns assuming a day count of 360 days, simplifying comparisons but differing from actual calendar days.
- Applies to short-term discount securities: Commonly used for instruments like Treasury bills, commercial paper, and municipal notes with maturities under one year.
- No coupon payments: Reflects return solely from price appreciation as these instruments do not pay periodic interest.
- Standardized quote: Enables investors to easily compare yields across similar discount instruments despite differences in price and maturity.
How It Works
Discount yield is calculated by dividing the difference between the face value and purchase price by the face value, then annualizing this figure using a 360-day day count. This approach simplifies yield quotes in money markets but can understate actual returns compared to other yield measures that use the purchase price as the base.
Because the yield is based on face value, it does not account for the full time value of money invested. Investors often convert discount yield to money market yield or bond equivalent yield for more accurate comparisons of effective returns across different instruments.
Examples and Use Cases
Discount yield is widely used by investors to evaluate short-term debt instruments and compare yields efficiently.
- Government securities: Investors buying Treasury bills rely on discount yield quotes to assess expected returns over their holding period.
- Municipal notes and baby bonds: These instruments often use discount yield for standardized pricing in the market.
- Bond investments: When analyzing fixed income options, including bond ETFs like those covered in our best bond ETFs guide, understanding discount yield helps you compare short-term holdings effectively.
- Corporate bonds: Investors in bonds such as those issued by BND funds consider discount yield when evaluating the price relative to maturity value.
Important Considerations
While discount yield is useful for quick comparisons, it has limitations. Since it uses a 360-day year and face value basis, it can underestimate effective returns compared to yields based on actual days or purchase price. Be cautious when comparing discount yields to other yield types, and consider converting to money market or bond equivalent yields for more precise analysis.
Understanding the specific conventions of discount yield helps you make better-informed decisions when investing in short-term discount securities or evaluating portfolios that include instruments priced below face value.
Final Words
Discount Yield offers a quick, standardized way to assess returns on discount securities but tends to understate true investment yield due to its face value basis and 360-day year. To get a clearer picture, compare Discount Yield with other yield measures like Money Market Yield before making investment decisions.
Frequently Asked Questions
Discount Yield (DY), also known as bank discount yield, measures the annualized return on discount securities like Treasury bills by calculating the discount relative to face value using a 360-day year convention.
Discount Yield is calculated by dividing the difference between the face value and purchase price by the face value, then annualizing this using a 360-day year based on the days to maturity. The formula is DY = ((F - P) / F) × (360 / t).
The 360-day year convention is used for simplicity and standardization in money markets, although it can cause discrepancies when comparing Discount Yield to yields calculated using actual days in a year, like bond equivalent yields.
Discount Yield is commonly applied to short-term, zero-coupon instruments such as Treasury bills, commercial paper, and municipal notes that do not pay periodic interest.
Discount Yield uses face value in its calculation, which typically understates the return compared to Money Market Yield and Bond Equivalent Yield that use purchase price and different day count conventions, resulting in DY being the lowest among them.
Discount Yield ignores the time value of the invested amount and uses a 360-day year, which often leads to lower yield figures compared to other more precise yield calculations like Money Market Yield or Bond Equivalent Yield.
Yes, by rearranging the formula, you can calculate the purchase price of a T-bill when you know the Discount Yield, face value, and days to maturity, allowing investors to price discount securities accurately.
