The discount yield is a measure used primarily to calculate the percentage return on short-term bonds and treasury bills that are sold at a discount from their face value. This financial metric is essential for investors seeking to understand the profitability of such investments.
Formula for Discount Yield
The calculation of the discount yield is given by the following formula:
where:
- Face Value is the bond’s nominal or par value.
- Purchase Price is the amount paid for the bond.
- Days to Maturity is the number of days remaining until the bond matures.
Components and Calculation
Face Value
The face value is the amount paid to the bondholder at maturity. It is also known as the par value or principal.
Purchase Price
The purchase price is the actual amount paid for the short-term bond or treasury bill. This is less than the face value since these securities are issued at a discount.
Days to Maturity
This is the number of days from the purchase date to the maturity date of the bond. Most short-term bonds and treasury bills mature within one year.
Practical Examples of Discount Yield
Example 1: Treasury Bill Calculation
Suppose an investor purchases a treasury bill with a face value of $10,000 for $9,700, and the bill matures in 180 days. The discount yield can be calculated as follows:
Example 2: Bond Discount Yield
Consider a short-term bond with a face value of $5,000 purchased for $4,850 and maturing in 90 days:
Historical Context and Applicability
The discount yield concept has been vital in the realm of fixed-income securities for a long time, aiding investors and financial professionals in making informed investment decisions. It has been particularly significant in the trading of treasury bills and other short-term government securities.
Comparisons and Related Terms
Yield to Maturity (YTM)
Unlike the discount yield, YTM considers the total return an investor will receive if the bond is held until maturity, including interest payments.
Current Yield
Current yield focuses on the bond’s current income without accounting for capital gains or losses associated with the purchase price being different from the face value.
Coupon Rate
The coupon rate is the annual interest rate paid by the bond issuer based on the bond’s face value, irrespective of its current market price.
Special Considerations
- Market Conditions: The discount yield can be influenced by prevailing interest rates and market conditions.
- Investment Horizon: Suitable primarily for short-term investments due to the inclusion of the 360-day convention.
FAQs
Why is the 360-day year convention used in the discount yield formula?
Can the discount yield be negative?
How is the discount yield used by investors?
References
- Fabozzi, F.J., & Mann, S.V. (2012). The Handbook of Fixed Income Securities. McGraw Hill.
- Mishkin, F.S. (2019). The Economics of Money, Banking, and Financial Markets. Pearson Education.
The discount yield is a crucial financial metric that helps in evaluating the return on short-term bonds and treasury bills sold at a discount. By understanding its formula and components, investors can effectively compare and assess the profitability of various fixed-income investments.
