What are pure discount bonds?

Unlike most other bonds, pure discount bonds do not carry an explicit interest rate. Instead, they offer a lump sum depending on the current face value of the bond on a future date. The difference between the purchase value and face value gives the YTM or return to the investor in such bonds.

Pure discount bonds have −

  • Purchase value − The present price of the bond.

  • Maturity value − That is equal to a face value in the future.

  • Maturity period − The time taken for maturity.

Discount bonds have a lower price than the par value or a bond that is being traded at the secondary market at a cost below the par value. The bond is considered a discount bond because the bond's coupon rate is lower than its interest rates.

Working Mechanism

An investor in bonds expects interest to be paid on the bond by the issuer. However, the exact value of a bond may go up or down in the market. When the market interest goes up, the bond value decreases. The bond therefore should be sold at a discount. That is precisely why it is called a discount bond.

Note − The purchasers of the discount bonds have to pay a price lower than its face value. However, this doesn't guarantee a profit on investments.

Reasons for a bond being sold at a discount

There can be many reasons for a bond being sold at a discount, the major three of which are −

  • Credit Rating Review − If a bond rating agency lowers the rating of a bond, people would seek protection in terms of discounts.

  • Bond issuer's risk of default − If the default probability is higher, investors would seek a discount on the par value of the bond.

  • Fluctuating Interest rates − When the market interest goes above the coupon rate, the bond will trade at a discount which lets the issuer earn sufficient revenues too.

The Value of a Discount Bond

It is easy to find the value of pure discount bonds, as only one payment is required at the end of the maturity period of the bond. The market interest rate or the market rate is taken as the interest rate of the bond. The present value of this amount is the bond's value.

$$ 𝐵_{0} = \frac{𝑀_{𝑛}}{(1 + 𝐾_{𝑑} )^𝑛}$$

For example, if the bond has a face value of INR 200,000, a maturity of 30 years, and a current market rate of 8%, what would be the current price of the bond?

Using the formula, we get,

$$ 𝐵_{0} = \frac{2,00,000}{(1 + 0.08)^{30}} = \frac{2,00,000}{10.062} = INR\:19,875 $$

So, the value of the pure discount bond today will be INR 19,875.