Definition
A discount bond is a type of bond that is sold for less than its face value, or par value. This means the investor purchases the bond at a price lower than its original value. When the bond matures, the bondholder will receive the face value of the bond, thus earning a profit between the purchase price and the paid-out face value.
Key Takeaways
- A Discount Bond is sold for less than its face (or par) value. This means the purchase price is lower than its original price.
- The difference between the face value of the bond and its purchase price is what the investor will earn. This is because at maturity, the face value of the bond is paid back to the investor.
- The advantage of discount bonds is that they can potentially offer higher returns compared to traditional bonds. This is due to the additional earnings from the difference between the purchase and face value.
Importance
A Discount Bond is a crucial finance term as it represents a bond that is purchased for less than its face value. This concept is essential in the financial world because it allows investors to potentially generate a significant return on investments.
As the bond moves towards its maturity date, its value steadily increases until it equals the face value. Therefore, the potential profit derived from the difference between the purchase price and the face value is the reason buyers might be interested in discount bonds.
Furthermore, this concept also helps in understanding market conditions, particularly interest rates, as bonds are typically sold at a discount when the market interest rate surpasses the bond’s fixed interest rate. Therefore, understanding the significance of discount bonds is fundamental for investment decisions and risk management in finance.
Explanation
Discount bonds serve a significant purpose in the world of finance as a tool for companies and governments to raise funds. Essentially, they are sold at a lower price than their face value, which essentially represents the loan made by the bondholder to the issuer. The principal incentive for an investor to purchase a discount bond is the anticipation of capital gains when the bond matures at its face value.
These capital gains are broadly the difference between the purchase price and the amount received upon maturity. The issuer, on the other hand, gets immediate funds to finance their operations or initiatives without having to immediately repay the full amount. Moreover, the use of discount bonds can help issuers capitalize on interest rates fluctuations.
When interest rates are high, it becomes more expensive for companies and governments to borrow. By issuing bonds at a discount, they effectively lock in lower interest rates, as the difference between the purchase price and the face value serves as the interest on the loan. Consequently, discount bonds represent an effective financing strategy for issuers, while offering the potential for substantial returns, hence yield, for investors.
Additionally, they may provide a more affordable entry point to the market for smaller or retail investors due to their lower purchase price.
Examples of Discount Bond
U.S. Treasury Bills: These are government-issued short-term investments, usually for a term of less than one year. They are issued at a discount from their face value. For example, an investor might purchase a treasury bill with a face value of $1,000 for $When the treasury bill matures, the government pays the investor the face value of the bill. In this example, the investor would gain $
Corporate Bonds: Let’s say a company issues a bond with a face value of $10,000 and an interest rate of 5%, but due to prevailing market interest rates being higher than the bond coupon rate, it needed to be priced at a discount to attract investors. So, the bond might be sold for $9,Upon maturity, the investor would receive the face value, therefore making a gain of $
Municipal Bonds: Often issued by local governments or towns, for instance, a town might issue a bond at a discount to fund a community project, such as a new school or park. An investor might purchase a bond with a face value of $20,000 for $18,Once the bond reaches maturity, they will receive the full face value amount, generating a profit of $2,
FAQ Section: Discount Bond
What is a discount bond?
A discount bond is a bond that is purchased for less than its face value. The face value is paid at maturity. The discount on the price effectively represents the interest paid to the bond holder.
How does a discount bond work?
When you buy a discount bond, you will pay less than the face value upfront. When the bond reaches maturity, you will receive the full face value of the bond. The difference between the purchase price and the face value represents the interest you earned on the bond.
What are the benefits of a discount bond?
One benefit of a discount bond is that you know exactly how much you will earn if you hold the bond until maturity since the return is set by the difference between the purchase price and the face value. It is also considered a low-risk investment because the issuer has a legal obligation to pay back the face value at maturity.
What are the risks associated with discount bonds?
Like any investment, discount bonds come with risks. The main risk is that the issuer might default and not be able to pay back the face value at maturity. This risk is higher with corporate bonds than with government bonds. Additionally, bonds can lose value over time due to inflation, especially if the term of the bond is long.
How are discount bonds taxed?
The interest earned on a discount bond is taxed as ordinary income, not as a capital gain. However, some types of bonds, such as municipal bonds, are often exempt from certain taxes.
Related Entrepreneurship Terms
- Par Value
- Face Value
- Yield to Maturity (YTM)
- Market Interest Rate
- Coupon Rate
Sources for More Information
- Investopedia – A comprehensive online financial dictionary featuring thousands of definitions with a focus on investing, finance, and market terminology.
- YourDictionary – A broad online dictionary that also covers financial terms, including discount bonds.
- Corporate Finance Institute – They offer a financial dictionary as well and provide clear and easy-to-understand explanations for various financial terms, including discount bonds.
- Fidelity – Fidelity is primarily a brokerage firm, but is also an excellent resource for explanations of financial terms and concepts, including discount bonds.
