What is a discount (in finance)?
A discount occurs when a security trades for less than a reference value used to judge it. For bonds the reference is usually the face (par) value; for stocks or other instruments the comparison may be an estimate of intrinsic worth. The term should not be confused with the discount rate, which is an interest rate used when valuing cash flows.
Key definitions (jargon explained)
– Par value (face value): the amount the issuer promises to repay at maturity. Many retail bonds use $1,000 as par.
– Coupon: the periodic interest payment a bond makes (expressed as a rate of par).
– Discount bond: a bond whose market price is below par.
– Premium bond: a bond whose market price is above par.
– Pure discount instrument: a security that pays no coupons and is sold below par; the return comes entirely from price appreciation to par at maturity (zero-coupon bonds are a common example).
– Deep discount: loosely used for bonds trading about 20% or more below comparable market value.
Why bonds trade at a discount
– Market interest rates rise relative to a bond’s coupon. Bond prices and market yields move in opposite directions: if newly issued bonds offer higher coupons, older lower-coupon bonds become less attractive and their market prices fall.
– Credit or issuer-specific risk increases. If the issuer’s creditworthiness worsens, buyers demand a lower price to compensate for higher default risk.
– Liquidity, time to maturity, taxation, and market sentiment can also influence discounts.
Discount vs. premium—how to measure
– Discount in dollars = Par price − Market price.
– Discount as a percentage of par = (Par − Market price) / Par.
– Premium as a percentage = (Market price − Par) / Par.
Worked numeric examples
1) Simple discount in dollars and percent (bond example)
– Par = $1,000; Market price = $990.
– Discount in dollars = $1,000 − $990 = $10.
– Discount percentage = $10 / $1,000 = 1.00%.
2) Annualized return for a pure discount (zero-coupon) bond
– You buy a zero-coupon bond for $900 that pays $1,000 at maturity in 3 years.
– Annualized yield (compound) = (FV / Price)^(1/n) − 1 = (1,000 / 900)^(1/3) − 1.
– Calculation: (1.111111)^(0.3333) − 1 ≈ 1.0357 − 1 = 0.0357 → about 3.57% per year.
Assumptions: no default, no interim payments, and yield quoted as an annual effective rate.
Pure discount instruments and zero-coupon bonds
A pure discount security pays nothing until maturity and is issued at a meaningful discount to par. The investor’s return equals the capital appreciation to par. Because they have no coupon payments, price moves can be larger (higher duration), making zero-coupon and deep-discount bonds typically more volatile than coupon-paying bonds.
Practical checklist for evaluating a bond trading at a discount
1. Compare the bond’s coupon to current market rates. Is the coupon materially below prevailing yields?
2. Check credit quality: has the issuer’s rating or fundamentals deteriorated?
3. Calculate yield-to-maturity (YTM) or the annualized return for a pure discount using (FV/Price)^(1/n) − 1 for a simple estimate. For coupon bonds, compute standard YTM.
4. Consider time to maturity—longer maturities magnify price sensitivity to rate changes.
5. Assess liquidity and bid-ask spreads—thinly traded bonds can show larger discounts.
6. Review tax treatment and any embedded options (callable bonds can trade differently).
7. Factor in your risk tolerance and investment horizon.
Other meanings of “discount”
– Stocks or derivatives can trade at discounts relative to an estimated intrinsic value or NAV (net asset value); discounts there are often driven by supply/demand, corporate actions, or investor
sentiment—expectations about future earnings, interest rates, or liquidity. Below are practical definitions, calculations, examples, and decision checklists you can use when you encounter the term “discount” in different markets.
Key definitions and simple formulas
– Discount (absolute): For a bond or security with a stated par or net asset value (NAV), discount = Par (or NAV) − Market price.
– Discount (percent): Percent discount = (Par or NAV − Market price) / (Par or NAV). Express as a percentage.
– Zero-coupon (pure discount) yield estimate: For a zero-coupon security, an annualized yield can be approximated by Y ≈ (FV / Price)^(1/n) − 1, where FV = face value, Price = current price, and n = years to maturity.
– Discount to NAV (for funds/ETFs): Discount to NAV = (NAV per share − Market price per share) / NAV per share.
Worked numeric examples (step-by-step)
1) Bond trading at a discount
– Par value = $1,000. Market price = $950.
– Absolute discount = $1,000 − $950 = $50.
– Percent discount = $50 / $1,000 = 0.05 = 5%.
2) Zero-coupon (pure discount) example
– Face value (FV) = $1,000. Price = $620. n = 10 years.
– Compute FV / Price = 1,000 / 620 = 1.612903.
– Compute annualized yield = (1.612903)^(1/10) − 1.
– Using a calculator: yield ≈ 1.0489 − 1 = 0.0489 = 4.89% per year.
– Note: This is the geometric annualized yield. For coupon bonds use an iterative YTM calculation or financial calculator.
3) Fund/ETF discount to NAV
– NAV per share = $20. Market price = $18.
– Discount to NAV = ($20 − $18) / $20 = $2 / $20 = 0.10 = 10%.
Discount versus premium
– Discount: Market price par (or NAV). For bonds this usually means lower yield than a par-priced bond with the same coupons; for funds it often indicates investor enthusiasm or scarcity.
– Relationship to yield: For fixed-coupon bonds, price and yield move inversely. All else equal, a discount implies a higher yield-to-maturity than a par-priced bond.
Practical decision checklist when you see a discount
1. Confirm what “par” or “value” is (par value, NAV, intrinsic estimate).
2. Check liquidity: look at recent trade sizes and bid–ask spread. Thin liquidity can exaggerate discounts.
3. Review credit and fundamentals (for corporate or municipal bonds): rating changes, covenant breaches, or issuer news.
4. Compute the relevant yield measure: zero-coupon formula for pure discounts; yield-to-maturity (YTM) for coupon bonds; current yield may be useful for income focus.
5. Consider time to maturity and interest-rate sensitivity: longer maturities amplify price moves.
6. Investigate structural reasons (for funds): creation/redemption mechanics, closed-end status, takeover speculation, or concentrated share ownership.
7. Check tax and accounting implications: original issue discount (OID) and realized gains may have specific tax treatments—consult tax guidance.
8. Compare alternatives: is the extra yield (or discount) compensation adequate for added credit, liquidity, or event risks?
Common pitfalls and cautions
– A discount is not automatically a bargain. It may reflect real deterioration in cash flows, default risk, or illiquidity.
– For closed-end funds, discounts can persist for long periods due to investor sentiment and structural supply/demand imbalances.
– Using percent discount alone ignores maturity and coupon structure for bonds; always convert to yield measures to compare.
– Beware of stale NAVs (especially for thinly traded or illiquid assets) — reported NAVs may lag market information.
Quick reference for bond math (reminders)
– Price = present value of future cash flows (coupons and principal) discounted at the market rate.
– Yield-to-maturity (YTM) solves Price = Σ [Coupon / (1+Y)^t] + [Par / (1+Y)^n] — typically solved numerically.
– Current yield = Annual coupon / Price. Useful for snapshot income comparison but ignores capital gain/loss at maturity.
Where to learn more (reputable sources)
– Investopedia — Discount definition and examples: https://www.investopedia.com/terms/d/discount.asp
– U.S. Securities and Exchange Commission (SEC) — Mutual funds/ETFs and pricing: https://www.sec.gov/fast-answers/answersmutfundhtm.html
– Internal Revenue Service (IRS) — Original Issue Discount (OID) guidance: https://www.irs.gov/taxtopics/tc403
– Financial Industry Regulatory Authority (FINRA) — Information on bond pricing and liquidity: https://www.finra.org/investors/learn-to-invest/basics/bonds
Educational disclaimer
This content is educational and informational only. It is not individualized investment, tax, or legal advice. For decisions that affect your finances or taxes, consult a licensed professional.