Bond Discount - Explained
What is a Bond Discount?
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Table of ContentsWhat is a Bond Discount?How Does a Bond Discount Work?Academic Research on Bond Discount
What is a Bond Discount?
Bond discount refers to the amount by which a bond market's price is lesser than the principal amount ready at maturity. This amount, known as a par value or face value, is usually $1,000.
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How Does a Bond Discount Work?
A bonds primary characteristics are its face value, market price, and coupon rate. An issuer pays coupons to the bondholders as a reward for the amount loaned within a particular period. The amount of principal loan is paid back to the investor at maturity. This amount equals the bonds face value. $1,000 is the par of the majority of corporate bonds. Certain bonds are sold at a discount, at par, or even at a premium. A bond thats sold at face has a coupon rate equivalent to the economy's predominant interest rate. An investor that buys this bond would have an investment return that's ascertained by the cyclic coupon payments. A bond whose market price is greater than its face value is known as a premium bond. Supposing the stated interest of the bond is more than those anticipated by the present bond market, then the bond would be attractive to investors. The market price of a bond given at a discounted price is usually below the par value, thus appreciating capital upon maturity because the greater par value is paid once the bond is due. The existing difference showing that the market price of a bond is lesser than its par value is the bond discount. For instance, a bond having a $1,000 par value that's trading at exactly $980 has a $20 bond discount. Furthermore, it is used to refer to the rate of the bond discount, an interest used in pricing bonds through current valuation calculations. Once the interest rate of the market surpasses the bond's coupon rate, bonds are then sold at a discount. For understanding, recall that bonds sold at face have coupon rates equivalent to the interest rate of the market. Once interest rate rises above coupon rate, the bondholders would then hold a bond with lesser interest payments. The existing bonds then experience value dip to show that new issues in the markets have rates that are more attractive. Supposing the value of the bond drops below face value, investors have a higher tendency to buy it since, at maturity, they would be paid back the face value. The current coupon payment value, as well as, the principal value needs to be ascertained in order to calculate the bond discount. For instance, imagine a bond having a $1,000 par value expected to mature within 3 years. Its coupon rate is 3.5% while the market's interest rate is a bit higher at 5%. Because interests are paid on a biannual basis, then the number of coupon payments would be 3 yrs x 2= 6, while interest rate for each period would be 5% 2 = 2.5%. Based on the information, the principal repayment's present value at maturity would be: PVprincipal = $1,000 (1.0256) = $862.30 Next, the current coupon payment value has to be calculated. 3.5% 2 = 1.75% would be the coupon rate per period. Then each interest payment per period would be 1.75% x $1,000 = $17.50. Then PVcoupon = (17.50 1.025) + (17.50 1.0252) + (17.50 1.0253) + (17.50 1.0254) + (17.50 1.0255) + (17.50/1.0256) Thus, PVcoupon = 17.07 + 16.66 + 16.25 + 15.85 + 15.47 + 15.09 = $96.39. The bond's market price is the summation of the current coupon payment value and the principal. Market Price = $862.30 + $96.39 = $958.69. Because the market price is lower than the face value, then the bond currently trades at a ($41.31) discount i.e. $1,000 - $958.69 = $41.31. Thus, 41.31 $1,000 = 4.13% is the bond discount rate. There are various reasons bonds trade at a discount to face value. Bonds that are on the secondary market having fixed coupons would trade at discounted rates once interest rates of the market begin rising. While the investor gets that exact coupon, the bond is discounted so as to correspond with predominant market yields. Furthermore, discounts also happen when supply of bond surpasses demand, when credit rating of the bond is reduced, or when there is an increase in the perceived default risk. On the other hand, a better credit rating or a falling interest rate might result in a bond trading at a premium. Often, bonds which are short-term are given at a discount, mainly in a situation where the bond is a zero-coupon bond. However, bonds that are on the secondary market might be trading at a bond discount. This happens when supply surpasses demand.