In-depth exploration of discount bonds, including their definition, how to calculate yield to maturity, associated risks, and practical examples.
A discount bond is a type of bond that is issued for less than its par (or face) value or trades for less than its face value in the secondary market. This generally happens when the coupon rate of the bond is less than the prevailing market interest rates.
Yield to Maturity (YTM) is a key concept when evaluating discount bonds, as it reflects the total return expected if the bond is held until it matures.
The formula to calculate YTM is complex and typically solved through iterative methods, but it fundamentally seeks to equalize the present value of all future cash flows (coupons and the repayment of par value) to the bond’s current market price.
Where:
Suppose you have a bond with a face value of $1,000, an annual coupon payment of $50, a current market price of $950, and 5 years to maturity. You would solve for YTM in the equation:
This would typically be solved using a financial calculator or software capable of iterative computation.
As interest rates rise, the price of previously-issued bonds generally falls. Discount bonds can be particularly sensitive to such changes because their lower coupon rates make them less attractive compared to newly issued bonds.
The likelihood of the bond issuer defaulting on payments can affect the market price and perceived value of the bond. Lower credit rating agencies signify higher credit risk.
Some discount bonds may be less liquid, meaning they can be harder to sell without affecting the bond’s price. This can be a significant risk if the investor needs to sell the bond before maturity.
Consider a corporation issuing a bond with a $1,000 face value at $950 due to a lower-than-market interest rate. An investor purchasing the bond at the discounted rate expects to benefit not only from the interest payments but also from the eventual repayment of the face value at maturity, resulting in an overall yield that compensates for the initially lower coupon payments.
Discount bonds can be attractive to investors looking for potential capital appreciation or those who believe interest rates will decrease in the future, making the lower coupon payments more competitive against newly issued bonds.
While discount bonds trade below their face value, premium bonds trade above their par value. The choice between the two will depend on the investor’s market outlook and yield requirement.