What Is a Discount in Finance?
In finance and investing, a discount occurs when a security trades below its fundamental or intrinsic value.
Key Takeaways
- In fixed-income trading, a discount occurs when a bond’s price is trading below its par or face value.
- Bonds may trade at a discount for various reasons, including rising interest rates or financial distress with the issuer.
- Discount bonds might signal concerns about the underlying company’s ability to meet debt obligations.
Understanding Bond Discounts
The par value of a bond is typically set at $1,000, which is the amount the issuer repays to the investor at maturity. If the bond’s market price is lower than $1,000, it is said to be trading at a discount. A bond may also trade at a premium when its market price is above its face value.
Factors that lead to a bond trading at a discount include the inverse relationship between bond prices and interest rates. If a bond has a lower coupon rate than the prevailing interest rates, it becomes less attractive, prompting a discount price. For example, if a bond with a par value of $1,000 is currently selling for $990, it is trading at a discount of 1% or $10.
Some bonds with physical coupons attached were called coupon bonds. Examples of discount bonds include U.S. savings bonds and Treasury bills.
Deep Discounts and Pure Discount Instruments
A pure discount instrument is a bond that pays no interest until maturity and is sold at a significant discount. At maturity, the bondholder receives the full par value. For instance, purchasing a pure discount instrument for $900 that matures at $1,000 results in a $100 profit.
Zero-coupon bonds are examples of pure discount instruments. These bonds do not pay periodic interest but are sold at a deep discount, providing returns through price appreciation. A bond that trades at least 20% below market value can be termed deeply discounted.
Discounts vs. Premiums
The opposite of a discount is a premium, which occurs when a bond sells above its par value. A bond may sell at a premium if it offers a higher interest rate than the current market rate or has an excellent issuer track record.
Other Types of Discounts
Discounts apply not just to bonds but also to stocks, derivatives, products, and services. For stocks, discounts may help generate investor interest.
Companies may offer discounts to boost sales or attract customers. Cash discounts incentivize early payment by reducing the amount due if paid before the scheduled date, either by a percentage or a fixed amount.
Related Terms: Premium, Coupon Rate, Zero-Coupon Bond, Cash Discount, Par Value.
