A discount bond is a debt security sold below its face value, repaid at full face value at maturity, with the difference representing the earned interest.
A discount bond is a type of fixed-income security that is issued or traded at a price below its face (or par) value. Unlike coupon bonds that pay periodic interest, discount bonds typically do not pay interest during the life of the bond; instead, the investor receives the face value at maturity which is higher than the purchase price. The return to the investor is the difference between the bond’s purchase price and the amount repaid at maturity. This difference serves as the implied interest or yield earned on the investment. Discount bonds can be zero-coupon bonds, which explicitly make no interim interest payments, or bonds that are temporarily priced below par due to market factors such as changes in interest rates or credit risk. They are commonly used by issuers to raise capital and investors seeking a known return at a future date. In the context of finance and wealth management, discount bonds are a strategic asset class for fixed-income portfolios offering different risk and tax characteristics compared to coupon-bearing bonds.
Understanding discount bonds is essential for effective portfolio construction and income planning, particularly for entities focused on capital preservation and predictable cash flows. Discount bonds may offer tax advantages because the imputed interest is often subject to different tax treatment than coupon interest, influencing after-tax returns. Accurately valuing discount bonds supports improved reporting and performance measurement within a fixed-income allocation. Furthermore, incorporating discount bonds into an investment strategy helps balance risk and return, especially in low-interest environments or when seeking to lock in yields in anticipation of rate volatility. For trust or estate portfolios, the timing and certainty of returns from discount bonds can align well with liability matching and wealth preservation objectives.
Consider a discount bond with a face value of $1,000 maturing in 5 years, currently priced at $850. An investor purchases the bond for $850 and at maturity receives $1,000. The total interest earned is $150, implying a yield over the 5 years. This illustrates how the discount between price and face value represents interest income.
Discount Bond vs. Coupon Bond
While discount bonds are sold below face value and typically do not pay periodic interest, coupon bonds pay regular interest payments at a stated coupon rate and usually trade closer to their par value. Discount bonds offer returns through capital appreciation at maturity, whereas coupon bonds provide periodic interest income, affecting cash flow timing and tax considerations differently.
What distinguishes a discount bond from a regular bond?
A discount bond is sold for less than its face value and repays the full face value at maturity, with no or minimal interim interest payments; a regular (coupon) bond pays periodic interest and typically trades near its face value.
How is the yield on a discount bond calculated?
The yield on a discount bond is calculated based on the difference between the purchase price and the face value, annualized over the bond’s term to maturity, reflecting the bond’s capital appreciation as interest income.
Are discount bonds tax-efficient investments?
Discount bonds can offer tax advantages, as the imputed interest may be treated differently from coupon income; however, tax treatment varies by jurisdiction and investment type, so consulting a tax advisor is advisable.
