Discount bonds

Definition

Discount bonds are debt securities that are sold for less than their face value, meaning investors can purchase them at a lower price than the amount they will receive at maturity. The difference between the purchase price and the face value represents the investor's earnings when the bond matures. These bonds do not typically pay periodic interest, so the return comes solely from the appreciation of the bond's value over time.

5 Must Know Facts For Your Next Test

1. Discount bonds are particularly appealing to investors looking for a lower entry price while still aiming for a fixed return upon maturity.
2. The price of a discount bond will rise as it approaches maturity, reflecting the increased likelihood of the investor receiving the full face value.
3. In terms of taxation, investors may be subject to taxes on the accrued interest even though no actual cash payment is received until maturity.
4. These bonds are often issued by government entities or corporations looking to raise capital without immediate cash flow obligations.
5. Market conditions can significantly influence the pricing of discount bonds; economic factors such as interest rates can lead to fluctuations in their market value.

Review Questions

• How do discount bonds differ from regular bonds in terms of payment structure and investor returns?
  • Discount bonds differ from regular bonds primarily in that they do not pay periodic interest payments. Instead, they are sold at a price lower than their face value, and the investor's return is derived from the difference between the purchase price and the face value received at maturity. This means that while regular bonds provide consistent income through coupon payments, discount bonds offer a lump sum profit only at maturity.
• Evaluate how market conditions affect the pricing and appeal of discount bonds compared to other types of bonds.
  • Market conditions, such as prevailing interest rates and economic stability, play a crucial role in determining the pricing and attractiveness of discount bonds. When interest rates rise, existing discount bonds may become less appealing because newer issues may offer higher yields. Conversely, during periods of economic uncertainty, investors may favor discount bonds as a safer investment option due to their lower purchase price and fixed return at maturity. This shift in demand can lead to changes in market prices for these bonds relative to other bond types.
• Analyze the investment strategies that might be employed when considering discount bonds in a diversified portfolio.
  • When considering discount bonds within a diversified investment portfolio, investors might employ strategies focused on capital appreciation and risk management. By incorporating discount bonds, investors can potentially achieve higher returns without needing to invest large amounts upfront. Additionally, these bonds can serve as a hedge against market volatility since they tend to rise in value as they approach maturity. Furthermore, understanding the timing of interest rate changes can help investors decide when to buy or sell discount bonds to maximize gains while minimizing risks associated with holding them long-term.

Related terms

Face Value: The nominal value of a bond that is paid back to the bondholder at maturity, typically also known as par value.

Yield to Maturity (YTM): The total expected return on a bond if held until maturity, taking into account its current market price, par value, coupon interest rate, and time to maturity.

Zero-Coupon Bond: A type of bond that does not pay periodic interest but is issued at a discount and matures at its face value, similar to a discount bond.