Discount

By 
ADAM HAYES
 
 
Updated May 17, 2021
What Is a Discount?
A discount, broadly, refers to some reduction in the going price of an item or
asset. In finance and investing, a discount refers to a situation when a security is
trading for lower than its fundamental or intrinsic value.

In fixed-income trading, a discount occurs when a bond's price is trading below

its par or face value, with the size of the discount equal to the difference between
the price paid for a security and its par value. Bonds may trade at a discount for
several reasons, including rising interest rates, or due to credit issues or riskiness
associated with the underlying company compared to comparable bonds.

A discount should not be confused with the discount rate, which is an interest

rate used for computing the time value of money.

KEY TAKEAWAYS

 A discount refers to a reduction in price or cost compared to its sticker

price or fair value.
 Bonds trade at a discount when their market is lower than its face (par)
value.
 Bonds may trade at a discount for several reasons, including rising interest
rates, or financial distress with the issuer.
 Discount bonds may thus indicate the belief that the underlying company
may default on its debt obligations.
 Companies may offer cash discounts as incentivizes to customers or to
increase demand for their products or services.
Understanding Bond Discounts
The par value of a bond is most often set at $1,000. The par value is the amount
that the issuer will repay to an investor when the debt security matures. If the
price of the bond in the market is lower than $1,000 it is said to be trading at a
discount. A discount bond may be contrasted with a bond trading at a premium,
where the market price is above its face.

A bond may trade at a discount for several reasons, and since bond prices and
interest rates are inversely correlated, if a bond offers a lower interest (coupon)
rate than the prevailing interest rate in the economy it will become less attractive
than newly issued bonds with higher coupons, and be discounted accordingly.
Put differently, since the issuer is not paying as high of an interest rate to
bondholders, these bonds must command a lower price to be competitive, or else
no one would buy it.

Example
For example, if a bond with a par value of $1,000 is currently selling for $990, it is
selling at a discount of 1% or $10 ($1000/$990 = 1).

 
The term "coupon" comes from the days of physical bond certificates—as
opposed to electronic ones—when some bonds had coupons attached to them.
Some examples of bonds that trade at a discount include U.S. savings bonds
and Treasury bills.

Deep Discounts and Pure Discount Instruments

One type of discount bond is a pure discount instrument. This bond pays nothing
until maturity. The bond is instead sold at a sizeable discount, but when it
reaches maturity, it repays the bondholder the full par value. For example, if you
purchase a pure discount instrument for $900 and the par value is $1,000, you
will receive a total of $1,000 when the bond reaches maturity, for a profit of $100.

Investors will not receive regular interest income payments from pure discount
bonds. However, their return on investment is measured by the price
appreciation of the bond. The more discounted the bond at the time of purchase,
the higher the investor's implied rate of return at the time of maturity.

An example of a pure discount bond is a zero-coupon bond, which doesn't pay

interest but instead is sold at a deep discount. The discount amount is equal to
the amount lost by a lack of interest payments. Zero-coupon bond prices tend to
fluctuate more often than bonds with coupons.

The term deep discount doesn't only apply to zero-coupon bonds. It can be
applied to any bond that is trading at 20% or more below market value.

Discounts vs. Premiums

A discount is the opposite of a premium. When a bond is sold for more than the
par value, it sells at a premium. A premium occurs if the bond is sold at, for
example, $1,100 instead of its par value of $1,000. Conversely to a discount, a
premium occurs when the bond has a higher than market interest rate or better
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