Definition
A discount bond is a type of debt security that is issued for a price below its face (par) value. The difference between the purchase price and the face value, known as the bond discount, represents the interest earned by the investor.
Key Characteristics
- Face Value: The nominal amount the bond will be worth at maturity.
- Issue Price: The price at which the bond is sold to investors, which is less than face value.
- Yield: The bond’s yield will generally be higher than that of a similar bond issued at face value.
Types of Discount Bonds
- Zero-Coupon Bonds: Bonds that do not pay periodic interest and are issued significantly below their face value.
- Original Issue Discount (OID) Bonds: Bonds issued at a discount that provides a return at maturity when the issuer repays the face value.
Different Types
Zero-Coupon Bonds
Zero-coupon bonds do not make periodic interest payments. Instead, they are sold at a significant discount and mature at their face value, providing the investor with interest that has accumulated over time.
Original Issue Discount Bonds
These bonds are issued at a discount from their face value but may pay periodic interest. The bondholder receives both the periodic interest payments and a capital gain at maturity when the bond is redeemed for its face value.
Special Considerations
Risk Assessment
Investors need to carefully evaluate the issuing company’s creditworthiness, as the risk of default might be higher compared to bonds purchased at face value.
Tax Implications
Interest income from discount bonds, including zero-coupon bonds, is generally subject to taxation, and investors might need to consider the tax treatments in their specific jurisdictions.
Examples
U.S. Treasury Bills
Short-term securities offered at a discount and maturing at face value, commonly purchased by investors looking for safe, short-term investment opportunities.
Municipal Discount Bonds
Issued by local governments, these bonds often come with the added benefit of being exempt from federal income tax and, in some cases, state and local taxes as well.
Historical Context
The concept of discount bonds has been utilized for centuries as a means for entities to raise funds at a lower cost. Historical records show bonds being issued at a discount during times of war or economic distress when governments or corporations required quick capital.
Applicability
Investment Portfolio
Discount bonds can diversify an investment portfolio and provide steady returns over time, serving as a low-risk investment compared to stocks and other more volatile assets.
Inflation Protection
Investors often consider discount bonds as a hedge against inflation, although the real return might be impacted by the inflation rate over the bond’s duration.
Comparisons
Discount Bonds vs Premium Bonds
Discount bonds are issued below face value, whereas premium bonds are sold above face value. Both instruments cater to different investor needs based on their risk tolerance and income requirements.
Discount Bonds vs Regular Coupon Bonds
Regular coupon bonds pay periodic interest payments, whereas discount bonds may not, with the investor’s return realized primarily through price appreciation.
Related Terms
- Bond Discount: The difference between the bond’s face value and its market price when it is sold at a discount.
- Zero Coupon Bond: A bond that does not pay periodic interest payments and is issued at a discount to its face value.
FAQs
What is the primary benefit of investing in a discount bond?
Are discount bonds a safe investment?
How is the interest on a discount bond taxed?
References
- John C. Hull, “Options, Futures, and Other Derivatives”
- Fabozzi, Frank J., “Bond Markets, Analysis, and Strategies”
- U.S. Securities and Exchange Commission, “A Beginner’s Guide to Bond Investing”
Summary
Discount bonds offer a unique investment opportunity by allowing investors to purchase securities below face value, thereby realizing gains upon maturity. With various types available, each with distinct characteristics, discount bonds serve multiple strategic purposes in diversified investment portfolios, although investors should be aware of the associated risks and tax implications.
