what is a discount bond 
a discount bond is a security that is issued for less than its par or face value a discount bond may also be a bond that trades for less than its face value in the secondary market a bond is considered a deep discount bond if it is sold at a significantly lower price than par value usually at 20 or more a discount bond is contrasted with a bond sold at a premium understanding discount bondsa bond is a type of fixed income investment security they are issued by governments and companies that want to raise money the issuer becomes the debtor while the bondholder or investor becomes the creditor the bond s face value is how much the investor pays to purchase the security so they pay 1 000 for a bond with a face value of 1 000 since bonds are a type of debt security bondholders or investors receive interest from the bond s issuer this interest is called a coupon that is usually paid semiannually but depending on the bond may be paid monthly quarterly or even annually the investor also expects to receive the face value of the bond when it matures but some bonds trade at a lower value bonds that fall into this category are called discount bonds for example a bond with a 1 000 face value that s currently selling for 95 would be a discounted bond discount bonds can be bought and sold by both institutional and individual investors however institutional investors must adhere to specific regulations for the selling and purchasing of discount bonds a common example of a discount bond is a u s savings bond 1investors can convert older bond prices to their value in the current market by using a calculation called yield to maturity ytm ytm considers the bond s current market price par value coupon interest rate and time to maturity to calculate a bond s return the ytm calculation is relatively complex but many online financial calculators can determine the ytm of a bond 2special considerationssome bonds can come with deep discounts including distressed bonds this type of bond has a high likelihood of default and can trade at a significant discount to par which would effectively raise its yield to desirable levels however distressed bonds are not usually expected to pay full or timely interest payments as a result investors who buy these securities are making a speculative play a zero coupon bond is one example of a deep discount bond depending on the length of time until maturity zero coupon bonds can be issued at substantial discounts to par sometimes 20 or more because a bond always pays its full face value at maturity assuming no credit events occur zero coupon bonds will steadily rise in price as the maturity date approaches these bonds don t make periodic interest payments and will only make one payment of the face value to the holder at maturity 3advantages and disadvantages of discount bondsthere is just as much risk involved with discount bonds for the investor as there are rewards the same way there is for any other type of discounted product let s take a look at some of the pros and cons of buying this type of bond since the investor buys the investment at a discounted price it provides a greater opportunity for greater capital gains keep in mind that the investor must weigh this advantage against the disadvantage of paying taxes on those capital gains another key advantage is that discounted bonds may come with different maturity dates short and long term maturities this gives investors the ability to spread out default and interest rate risks even though it may be a discount bond the bondholder is also poised to get regular interest payments just like any regular bond there is an exception though as noted above zero coupon bonds do not pay any interest before the bond matures consideration of the creditworthiness of the issuer is important with any type of discount bond there are a couple of things that bondholders should be aware of when determining whether to purchase one of these bonds notably this is especially true with longer term bonds because they may be considered financially distressed companies high potential for capital gains as bonds sell at less than face valueavailable with short term and long term maturitiesinvestors may receive regular interest unless it s a zero coupon bondmay indicate issuer default falling dividends or reluctance of purchasershigher risk of default and financial distress with deeply discounted bondsdiscount bonds and interest ratesbond yields and prices have an inverse or opposite relationship as interest rates increase the price of a bond drops and vice versa a bond that offers investors a lower interest or coupon rate than the current market interest rate would likely be sold at a lower price than its face value this lower price is due to the opportunity investors have to buy a similar bond or other securities that give a better return 4let s say that interest rates rise after an investor purchases a bond the higher rate in the economy decreases the value of the newly purchased bond due to paying a lower rate versus the market that means if our investor wants to sell the bond on the secondary market they will have to offer it for a lower price should the prevailing market interest rates rise enough to push the price or value of a bond below its face value it s referred to as a discount bond however the discount in a discount bond doesn t necessarily mean that investors get a better yield than the market offers instead investors get a lower price to offset the bond s lower yield relative to interest rates in the current market for example if a corporate bond trades at 980 it is considered a discount bond since its value is below the 1 000 par value as a bond becomes discounted its coupon rate is lower than current yields conversely if current interest rates fall below the coupon rate offered on an existing bond the bond will trade at a premium or a price higher than face value 4discount bonds and default riskthe chances of seeing a discount bond appreciate are reasonably high as long as the lender doesn t default if you hold out until the bond matures you ll be paid the face value of the bond even though what you originally paid was less than the face value maturity rates vary between short term and long term bonds short term bonds mature in less than one year while long term bonds can mature in 10 to 15 years or even longer but the chances of default for longer term bonds might be higher as a discount bond can indicate that the bond issuer might be in financial distress discount bonds can also indicate the expectation of issuer default falling dividends or a reluctance to buy on the part of the investors as a result investors are compensated somewhat for their risk by being able to buy the bond at a discounted price example of a discount bondhere s a hypothetical example to show how discount bonds work let s say that company abc is offering investors a discount bond below are the details of the bond including the bond issue number coupon rate at the time of the offering and other information suppose the current price for the bond is 79 943 compared to the 100 price at the offering for reference the 10 year treasury yield trades at 2 45 making the yield on this bond much more attractive than current yields however company abc experienced financial difficulty over the last few years making the bond risky as we can see that it trades at a discount price despite the coupon rate being higher than the current yield on a 10 year treasury note the yield has traded higher than the coupon rate with some days as high as 7 which further indicates that the bond is deeply discounted since the yield is much higher than the coupon rate while its price is much lower than its face value 