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Discount bonds are bonds that sell for less than the face value of the bond. In many cases, a discount bond will also be a zero-coupon bond. Like many bond issues, a discount bond normally pays the original purchase price plus a fixed or variable amount of interest over the life of the bond.
Understanding how a discounted bond functions is not difficult. Assuming that a bond has a face value of $2,000.00 and is sold for $1,800.00, it can be said that the bond sold for a discount of $200.00. The new owner of the bond can look forward to earning a return on both the principal and any interest that is generated according to the terms and conditions surrounding the bond issue.
There can be several reasons why a discount bond may be available. One of the most common has to do with changes in market conditions that adversely impact the variable interest rate associated with the bond. The original buyer may determine that the return generated by the shift in interest rates is only going to continue to decrease. When that is the case, the original holder may choose to sell the bond at a discount before the applicable interest rate drops any further.
Another reason for the sale of a discount bond may have to do with financial hardship on the part of the bondholder. Bonds are relatively easy to sell quickly, since they tend to be less volatile than many other forms of investment. By discounting the cost of the bond by a small percentage, sellers have another reason to purchase the bond quickly. This can mean quick cash for the original holder that can be helped to alleviate a temporary cash crunch, or generate funds that the investor can use to purchase a different and more lucrative investment.
While many examples of the discount bond do pay interest, that is not always the case. When there is no interest involved, the investment is known as a pure discount bond. In this scenario, the buyer purchases the bond for less than the face value, but ultimately earns a return by eventually receiving the face value of the bond.
Coupon bonds like zero coupon bonds offer a discount on bonds. These bonds pay a discount bond yield to maturity.
They do not pay the yield until the bond matures. That is why these bonds are called zero coupon because the interest is paid at maturity.
A bond discount yield occurs when the actual yield of the bond is lower than the market rate of the bond. Premium and discount bonds are different. Premium bonds are sold at a higher value, while discount bonds are issued at a discount.