Key Takeaways
- Sold below face value, repaid at par.
- Yields exceed coupon rate via price gain.
- Prices drop when market rates rise.
- Deep-discount bonds may pay no coupons.
What is Discount Bond?
A discount bond is a debt security sold for less than its face value, with the issuer repaying the full par amount at maturity. This price difference allows investors to earn returns through capital appreciation and any coupon payments.
These bonds often arise when the coupon rate is lower than prevailing market interest rates or when issuer credit risk prompts investors to demand a discount.
Key Characteristics
Discount bonds have distinct features that affect their pricing and returns:
- Issued below par: Sold initially or traded at prices under 100% of face value due to interest rate changes or credit concerns.
- Capital gains: Price appreciates toward par value as maturity approaches, generating gains if held to term.
- Yield advantage: The earnings yield or yield to maturity exceeds the coupon rate because of the discount.
- Varied coupon structures: Includes zero-coupon bonds that pay no periodic interest but rely entirely on discount accretion.
- Tax treatment: Discount accretion may be subject to different rules than coupon interest, impacting after-tax returns.
How It Works
When market interest rates rise above a bond’s coupon rate, its price falls below face value to remain competitive. Investors buying at this discount earn a higher yield through the combination of coupon payments and the gain realized as the bond approaches maturity.
The bond’s discount is amortized over its life, reflected as imputed interest which can have specific tax implications, such as affecting the capital gains tax treatment. This mechanism makes discount bonds an attractive option for investors seeking returns exceeding standard coupon yields.
Examples and Use Cases
Discount bonds are utilized across various sectors and investment strategies:
- Corporate issuances: Companies like BND issue bonds that may trade at a discount when market rates shift.
- Airlines: Firms such as Delta may see their bonds trade below par due to sector volatility or credit perceptions.
- Bond ETFs: Investors can access diversified portfolios of discount bonds through funds like those featured in best bond ETFs, balancing risk and return.
Important Considerations
While discount bonds offer enhanced yields, they carry risks including credit default and interest rate fluctuations. Understanding the bond’s price behavior and tax treatment is essential for optimizing returns.
Liquidity can be limited, especially for deep-discount or zero-coupon bonds, so consider your investment horizon and risk tolerance carefully when including discount bonds in your portfolio.
Final Words
Discount bonds offer a way to earn returns through price appreciation when purchased below face value, especially in rising interest rate environments. To make the most of these opportunities, compare yields and credit quality across issuers to identify bonds that align with your risk tolerance and investment horizon.
Frequently Asked Questions
A discount bond is a debt security sold for less than its face value, with the issuer repaying the full face value at maturity. Investors earn returns through the bond’s price appreciation and any coupon payments.
Discount bonds typically trade below par when their coupon rate is lower than current market interest rates or when there are concerns about the issuer’s credit risk. This makes them less attractive at face value, leading investors to pay less.
YTM represents the total annualized return if the bond is held to maturity, including coupon payments and the capital gain from the discounted purchase price to par value. It usually exceeds the coupon rate for discount bonds.
Prices of discount bonds are affected by market interest rates, issuer creditworthiness, economic news, sector risks, and timing related to coupon payments, with prices generally rising as maturity approaches if no default occurs.
Investors earn returns through periodic coupon payments and capital gains as the bond’s price appreciates from the discounted purchase price up to its face value at maturity.
Deep-discount bonds trade at 20% or more below par value, often structured as zero-coupon bonds with no periodic interest, relying solely on repayment at maturity for returns.
In some cases, like non-registered accounts in Canada, capital gains from discount accretion are taxed at a lower rate than interest income, making discount bonds more tax-efficient compared to par bonds or GICs.
Discount bonds can be issued new when market rates exceed the coupon rate or can trade at a discount in secondary markets due to changes in interest rates or credit quality.
