Discounts: Definition and Types

Key takeaways
* In finance, a discount means a security is trading below its intrinsic or face value.
* For bonds, a discount occurs when market price is below par (commonly $1,000); reasons include rising market interest rates or increased credit risk.
* Pure discount instruments (e.g., zero-coupon bonds) are sold below par and pay no periodic interest.
* A discount is the opposite of a premium; other forms of discount include stock issue discounts, retail price discounts, and cash discounts for early payment.

What is a discount?

In investing, a discount describes when a security sells for less than its fundamental or stated value. For bonds, this means the market price is below the bond’s par (face) value—the amount the issuer promises to repay at maturity. The term “discount” here should not be confused with the “discount rate,” which refers to an interest rate used in time-value-of-money calculations.

Bond discounts: why they happen

Bonds commonly trade at a discount for these reasons:
* Interest rate changes: Bond prices and market interest rates move inversely. If prevailing interest rates rise after a bond is issued, older bonds with lower coupon rates become less attractive and fall in price.
* Credit risk: If the issuer’s perceived creditworthiness deteriorates, investors demand a lower price to compensate for increased default risk.
* Market liquidity and supply-demand dynamics.

Example: if a bond with $1,000 par value trades at $990, it is sold at a discount of $10, which equals 1% of par (($1,000 − $990)/$1,000 = 1%).

Coupon and price relationship

A bond’s coupon is the periodic interest payment promised to bondholders. When a bond’s coupon is lower than current market rates, the bond must trade at a discount to offer a competitive effective yield. Conversely, bonds with coupons above market rates trade at a premium.

Pure discount instruments and zero-coupon bonds

A pure discount instrument pays no periodic interest; it is sold below par and repays full par at maturity. The investor’s return is the difference between purchase price and par at maturity. Examples:
* Zero-coupon bonds: issued at a deep discount and do not pay coupons. Returns accrue via price appreciation to par.
Because they lack coupon payments, zero-coupon and other deep-discount instruments tend to exhibit greater price volatility than coupon-bearing bonds.

Deep discount

“Deep discount” generally refers to securities trading at a substantial reduction—commonly characterized as 20% or more below market or par value. Deep discounts can reflect high perceived risk or distressed conditions.

Discounts versus premiums

• Discount: market price < par (yield is higher than coupon rate).
• Premium: market price > par (yield is lower than coupon rate).
  Which side applies depends on the relationship between a bond’s coupon and prevailing market interest rates, as well as issuer quality.

Other uses of “discount”

The concept of discount appears beyond bonds:
* Stocks and derivatives: A stock or derivative can trade “at a discount” relative to a valuation benchmark (e.g., book value or net asset value).
* Retail or promotional discounts: Price reductions used to attract customers or increase sales.
* Cash discounts: Seller incentives for buyers to pay before the due date, typically expressed as a percentage reduction (for example, “2/10, net 30” means 2% off if paid within 10 days).

Summary

A discount signals that a security is priced below its stated or implied value. For bonds, discounts commonly arise from higher prevailing interest rates or worsening issuer credit. Understanding why a security trades at a discount helps investors assess potential returns and risks, including default risk and interest-rate sensitivity.