What is a Discount?

In the world of fixed-income trading, a discount refers to a bond whose price is trading below its par or face value. Generally, this occurs when interest rates are rising, as its yield-to-maturity is below that of similar bonds with higher interest rates, and thus investors have less incentive to purchase the lower-yielding bond. It can also indicate financial distress with the issuer, as investors may be seeking to limit their losses by selling the bonds before their value drops even further.

Rising Interest Rates

One of the primary causes of bonds trading at a discount is rising interest rates. As the rate of interest increase, the value of a bond falls, as newer, higher-yielding bonds become more attractive to investors. This causes an increase in demand for the higher-yielding bonds, resulting in a decrease in demand for the lower-yielding bonds, resulting in the lower-yielding bonds trading at a discount.

For example, if a bond has a face value of $1,000 and the current interest rates are 4%, then the bond will have a current market price of $1,040. If the interest rate rises to 5%, then investors may choose to purchase more of the higher-yielding bonds instead, resulting in the price of the original bond dropping to $1,030 as investors choose to sell the original bond to purchase the more attractive bond.

Issuer Financial Distress

The other main cause of bonds trading at a discount is financial distress with the issuer. If a company is facing significant financial struggles, investors may have concerns about its ability to repay its debt obligations. As a result, investors may choose to sell their bonds in the secondary market, in a bid to limit the impact of any further losses. In such cases, the bonds may trade at a discount because the offering price is adjusted to account for the uncertainty and thus make the bond a more attractive investment.

Conclusion

In summary, bonds can trade at a discount for a variety of reasons, such as rising interest rates or financial distress with the issuer. Discount bonds can indicate the belief that the underlying company may be heading for default on its debt obligations, leading to investors choosing to sell their bonds at the present market price in order to limit their losses. As such, investors need to be vigilant when analyzing the current market to identify potential discount bonds which may offer potential opportunities.