Discount Bonds

Discount Bonds are those bonds which has been sold by a customer at a price below the face value of the same. Suppose, a bond has a par value of hundred US dollars. Now, if an investor sells this bond in the market at a rate below the hundred dollar mark, say US $ 50, then this bond would be regarded as the Discount Bond. In such a case the bond would be said to have been sold at a discount of fifty US dollars.

Discount bonds surface only when there is a mis-match between the earlier rate of interest and the current one. This generally takes place in the situations where the current rate of interest rate offered by the issuing company is higher than the earlier one. In such a case the buyers would not find any incentive in buying the older bond because it is not lucrative enough in comparison to the new one. Thus the price mechanism of the bond market would pull the bond price down. This shows that the the rate of interest rate of the bond or simply bond yield has an inverse relationship with the bond price . The process of rising bond yield and declining bond price would continue until and unless the discrepancy between the two bond yields of the two different bonds equalize.

There are many bonds which are issued with an associated coupon rate which is below the on going rate of interest in the market. In such a situation, the issuer has to offer the bond at such a price which is below the current bond price. These types of bonds are also known as the Discount Bonds. One of the examples of such Discount Bonds are the Zero Coupon Bonds where the issuing company offers no coupon rate to the investors. Hence as a means of compensation package, the bond prices never go above the face value of the same.
The price sensitivity of the bonds are higher in case of the discount bonds in relation to the par and/or premium ones. The investors can make use of this phenomenon for making short term profit. The investors who have an expectation of falling rate of interest rate in the future, he would have a normal inclination towards the discount bonds than the par bonds and/or par bonds. But if the expectation of the investor is that the rate of interest rate would rise in the future then he would give more preference to a premium or par bond than the discount one.

Another factor which also gives rise to origination of Discount Bonds. If for any reason the credit rating of a bond decreases then the risks associated with the bond increases. Thus, for holding such a more risky bond, the investors demand more compensation in the form of bond yield. Consequently, the rise in the yield of the bond gives rise to the fall in bond price. In such a situation, if an investor sells the concerned bond at a bond price which is below the face value of the same then that bond would be referred to as the Discount Bond.

There is still another factor which also gives rise to Discount Bonds. If for any reason the liquidity risk of the issuer increases then the risks associated with the bond also increases. Thus, for getting hold of a more risky bond, the investors generally demand more compensation in the form of bond yield. The rise in the yield of the bond gives rise to the fall in bond price . In such a situation, if an investor sells the concerned bond at a bond price which is below the face value of the same then that bond is called the Discount Bond.