A discount bond is a bond issued for less than its principal value. Sometimes it also refers to a bond currently trading for less than its face value in the secondary market. For example, a discount bond with a $2,000 face value may be sold only for $100. Generally speaking, if a bond is sold at or over a price 20% lower than its face value, such a bond can be called a deep-discount bond.
Both individual and institutional investors can buy and sell discount bonds. The bond issuer will pay interest to bondholders. The interest is called a coupon that is paid semiannually. When interest rates increase, the bond price will tend to decrease.
If a bond provides a lower interest rate for investors than the current market interest rate, then the bond will probably be sold at a price lower than the par value. In another situation, once the coupon rate offered on a bond exceeds the current interest rate in the market, the bond will be traded at a price higher than the par value.
However, a discount bond does not mean that bondholders can obtain a better yield. Chances are that investors will have a lower price to offset the bond’s yield as opposed to the interest rates in the current market.
The pros and cons of discount bonds
Discount bonds can provide a high potential for capital gains, and investors are likely to receive regular interest. In addition, discount bonds are usually available both in long and short- term maturities so that investors can use the bond to adjust their portfolio needs.
However, discount bonds with longer-term maturities tend to have a higher risk of default. On some occasions, the bonds will also reflect bond issuers’ falling dividends, investors’ reluctance to buy the debt, or companies’ financial hardships.