A discount bond is a type of bond that is currently trading for less than its face value. Bonds could trade for less than the face value for a number of reasons. In some cases, discount bonds can be very attractive to investors because they provide an opportunity to increase the yield on the investment.

Discount Bond

When a bond is issued, it will have a face value. In most cases, when an investor purchases a bond directly from a company, she will have to pay the face value of the bond in order to secure it. For example, many bonds have a face value of $1000. This means that the investor has to purchase it for $1000, and then she will receive regular coupon payments from the issuing company. At the end of the bond term, she can redeem it for the full face value again.

When a bond is trading for discount, this means that it would trade in the secondary market for less than the face value. In the example, this means that the bond might be trading for $900 instead of $1000. The person that purchases it for $900 would still be able to receive coupon payments for the duration of the bond term. The individual would also be able to redeem the bond for the full $1000 at the end of the bond term. 

Interest Rates

One of the reasons that a bond could be trading for a discount is fluctuations in interest rates in the market. Bonds have an inverse relationship to interest rates in the market. If interest rates increase above the interest rates that are paid by the bonds, the bond values will decrease. This happens because investors will try to sell the bonds in order to get locked into bonds that pay a higher rate of interest. This concept also works in reverse, as the value of bonds will increase if interest rates in the market go down.

Default

Another reason that a bond could potentially trade for a discount is that the company is close to defaulting on the debt. If the company is close to default, investors may be trying to get anything that they can of the bonds that were issued by the company. Many investors will like to purchase these bonds at a deep discount because that provides them with a huge upside. If the company does not go into default, the bond would provide them with a great return on investment.

Zero Coupon Bonds

Zero coupon bonds also trade at a discount to the face value of the bond. With a zero coupon bond, the investor does not receive any regular interest payments, as he would with a traditional bond. Instead, he purchases the bond for a deep discount at the beginning of the bond term. He can then hold the bond until maturity and cash it in for the full face value. This gives him all of the interest that he would have earned at once.

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