Legal Definitions - bond discount

A bond discount occurs when a bond is sold for a price that is less than its face value (also known as par value). The face value is the principal amount that the bond issuer promises to pay back to the bondholder when the bond reaches its maturity date. While bonds are often initially issued at their face value, their market price can fluctuate based on various factors, primarily prevailing interest rates.

A bond discount typically arises when the interest rate offered by the bond (its coupon rate) is lower than the current interest rates available for similar investments in the financial market. To make the bond attractive to investors who could otherwise buy newer bonds with higher interest rates, its price must be reduced below its face value. This allows investors to achieve an overall yield comparable to market rates, as they pay less upfront but still receive the full face value when the bond matures.

• Example 1: Corporate Bond Issuance

  Imagine "Tech Innovations Inc." issues new bonds, each with a face value of $1,000 and a 3% annual interest rate. Shortly after, the national central bank raises its benchmark interest rates, causing newly issued bonds from other companies to offer 4% interest. To successfully sell its remaining 3% bonds, Tech Innovations Inc. must offer them at a discounted price, perhaps $960 per bond. An investor who buys at $960 will still receive $1,000 when the bond matures, plus the 3% interest payments. The $40 difference ($1,000 - $960) is the bond discount, which effectively increases the investor's overall return to be more competitive with the new market rates.

• Example 2: Municipal Bond for Public Works

  The city of "Riverbend" issues municipal bonds to fund a new public library, with each bond having a face value of $5,000 and offering a 2.8% tax-exempt interest rate. Before all the bonds are sold, a significant economic shift leads investors to demand higher returns on all new investments, pushing market rates up to 3.5%. To attract buyers for the remaining Riverbend bonds, the city's financial advisors decide to sell them at a discounted price, for instance, $4,900 each. This $100 reduction per bond is the bond discount, making the 2.8% interest rate more appealing given the changed market conditions.

• Example 3: Secondary Market Sale by an Investor

  An investor named David purchased a government bond two years ago for its face value of $10,000, which pays 2.5% annual interest. Today, David needs to sell the bond before its maturity date. However, current market interest rates for similar government bonds have increased to 3.2%. To find a buyer for his older, lower-yielding 2.5% bond, David must sell it for less than its $10,000 face value. He might sell it for $9,750. The $250 difference ($10,000 - $9,750) represents the bond discount, making his bond competitive with the newer, higher-yielding bonds available in the market.