Understanding Discount Yield: Unlocking Bond Investment Success
The discount yield is a powerful way to compute a bond’s return when sold below its face value. This crucial metric is prominently used to gauge the performance of various debt instruments, including municipal notes, commercial papers, and treasury bills.
Key Insights
- Discount yield quantifies the anticipated return of a bond acquired at a discount and held to maturity.
- The calculation is standardized with a hypothetical 30-day month and a 360-day year.
- It’s particularly relevant in assessing Treasury bills and zero-coupon bonds.
How to Calculate Discount Yield
Utilizing a simplified model of time measurement (a 30-day month and 360-day year), the calculation for discount yield becomes more straightforward.
How Discount Yield Works
Discount yield evaluates a discount bond investor’s return on investment if the bond is held until it matures. Different from other investment measured such as accretion and shape US Treasury bill returns, commercial paper, and various financial nodes. US Treasury bills have maturities extending up to six months (26 weeks), providing a clearer picture compared to other bonds maturing at longer terms.
Should an investor decide to sell before maturity, the earnings rate adjusts according to the new sale price. Imagine purchasing a $1000 corporate bond for $920 and selling it five years later for $1100. The investor final return needs deductible bond discount status for adjusting gross gain computation.
Zero-Coupon Bonds: Deep Dive
Zero-coupon bonds offer another glimpse into discount bond territory. Typically sold significantly below par value, sometimes at hefty discounts up to or more than 20%, these bonds return their full face value upon maturity. Despite the lack of periodic interest payments, zero-coupon bonds gradually rise in price as the maturity date converges.
Practical Example
Consider an investor buying a $10,000 treasury note at a discounted price of $9,700, maturing in 120 days. They face a discount worth $300, yielding calculated at:
($300 discount / $10,000 par value) * (360 / 120 days to maturity) = 9% discount yield.
Discount Yield vs. Bond Accretion: What to Know
Unlike the discount yield focused on discounted purchases, bond accretion smoothens earnings allocation of bond growth over time irrespective purchased at par, discount, or premium. For instance, if we acquire a $1000 corporate bond for $920 maturing in 10 years, the $80 discount tempoed balance moves towards bond income accompanied annual interest considerably by straight-line method or effective interest rate method distributing earnings each yearly until complete bond life.
Related Terms: Face Value, At a Discount, Discount Bond, Return on Investment, Treasury Bill, Par Value, Maturity Date, Zero-Coupon Bond, Bond Accretion.
