Discount Bond
Discount Bond
A bond trading below its par value (typically $1,000), occurring when market interest rates rise above the bond's coupon rate. For discount bonds, yield hierarchy is: Yield to Maturity (YTM) > Current Yield (CY) > Coupon Rate. Bondholders receive capital appreciation at maturity when the bond returns to par value, creating a taxable capital gain.
A corporate bond with a 4% coupon rate (paying $40 annually per $1,000 face value) now trades at $920 because newly issued bonds pay 5%. The bond trades at a discount because investors demand higher yields to compensate for the below-market coupon. At maturity, the bondholder receives the full $1,000 par value, realizing an $80 capital gain in addition to the annual interest payments.
Students often confuse the yield hierarchy for discount bonds (YTM > CY > Coupon) with premium bonds (Coupon > CY > YTM). Another common error is forgetting that the capital appreciation from discount to par at maturity is taxed as a capital gain, not ordinary income. Remember: discount bonds provide TWO sources of return (coupon payments + price appreciation), while premium bonds lose value as they approach maturity.
How This Is Tested
- Identifying which yield is highest for a discount bond (always YTM)
- Understanding why bonds trade at a discount when market rates rise above coupon rate
- Calculating the capital gains tax implication when a discount bond matures at par
- Comparing discount bonds to premium bonds based on yield relationships
- Determining appropriate discount bond recommendations based on interest rate expectations
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Par Value Standard | $1,000 per bond | Discount bond trades below this standard par value |
| Yield Hierarchy (Discount Bonds) | YTM > Current Yield > Coupon Rate | This relationship always holds true for bonds trading at a discount |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Marcus, age 58, expects interest rates to decline over the next 5 years as the Federal Reserve eases monetary policy. His adviser recommends purchasing corporate bonds currently trading at a discount due to recent rate increases. Which of the following best explains the potential benefit of this strategy for Marcus?
B is correct. When interest rates decline, existing bonds trading at a discount become more valuable because their fixed coupon payments are now closer to (or potentially above) new market rates. The bond price will appreciate toward par value, creating capital gains. This price appreciation, combined with the regular coupon payments, provides total return for Marcus.
A is incorrect because discount bonds actually provide LOWER current income than premium bonds with the same maturity and credit rating. The discount exists precisely because the coupon rate is below market. C is incorrect because capital appreciation from discount to par IS subject to capital gains taxation. D is incorrect because coupon rates are fixed at issuance and never change; only the bond's market price adjusts to reflect current interest rate conditions.
The Series 65 exam frequently tests the relationship between interest rate movements and bond prices, particularly for discount bonds. Understanding that falling rates cause discount bonds to appreciate (and vice versa) is essential for making appropriate recommendations based on interest rate forecasts. Questions often present scenarios asking which bond type benefits most from expected rate changes.
What causes a bond to trade at a discount to its par value?
C is correct. A bond trades at a discount when market interest rates rise above the bond's fixed coupon rate. Investors demand a discount (lower price) to compensate for receiving below-market interest payments. For example, if a bond pays a 4% coupon but new bonds pay 5%, the 4% bond must trade below par so its yield to maturity matches current market rates.
A (credit upgrade) is incorrect because improved credit quality would cause the bond to trade at a PREMIUM, not a discount. Better credit means lower risk, which increases bond value. B (rates declining) is incorrect because this causes bonds to trade at a premium, not a discount. When rates fall below the coupon, the bond becomes more valuable. D (approaching maturity) is incorrect because all bonds (discount, premium, or par) converge toward par value as maturity approaches, regardless of their current trading price.
Understanding the inverse relationship between interest rates and bond prices is fundamental to Series 65 exam success. Questions repeatedly test whether you can identify WHY a bond trades at a discount (rates rose above coupon) versus a premium (rates fell below coupon). This concept appears in suitability, risk assessment, and portfolio construction questions throughout the exam.
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C is correct. For ALL discount bonds, the yield hierarchy is always: Yield to Maturity (YTM) > Current Yield (CY) > Coupon Rate. Here's why:
ā¢ Coupon Rate = 5% (fixed, based on par value)
ā¢ Current Yield = $50 annual coupon Ć· $900 market price = 5.56% (higher than coupon because price is below par)
ā¢ YTM = approximately 6.5% (higher than both because it includes the $100 capital gain at maturity spread over 8 years, plus the annual $50 coupon)
YTM is highest because it accounts for both the annual coupon payments AND the $100 price appreciation from $900 to $1,000 at maturity.
A represents premium bond hierarchy (reversed). B mixes the correct order incorrectly. D is incorrect because the three yields are only equal when a bond trades exactly at par ($1,000).
Yield hierarchy questions appear on virtually every Series 65 exam. You must instantly recognize that discount bonds follow the pattern: YTM > CY > Coupon. This relationship is fundamental to bond pricing, comparative analysis, and determining appropriate recommendations. The exam tests this concept in multiple formats: direct recall, calculation-based questions, and scenario-based suitability questions.
All of the following statements about discount bonds are accurate EXCEPT
C is correct (the EXCEPT answer). The capital gain realized when a discount bond matures at par IS subject to capital gains taxation. This is a common misconception. When you purchase a bond at $900 and receive $1,000 at maturity, the $100 difference is a taxable capital gain (long-term if held over 1 year). The IRS treats this price appreciation as investment income subject to capital gains tax rates.
A is accurate: discount bonds have below-market coupon rates, which is precisely why they trade below par. Investors demand a discount to compensate for receiving lower-than-market interest payments. B is accurate: as maturity approaches, all bonds (discount, premium, or par) converge toward par value. Discount bonds appreciate from below par to par. D is accurate: YTM includes both coupon income AND the annualized capital appreciation to par, making it higher than current yield (which only considers annual coupon Ć· market price).
The Series 65 exam tests your understanding of the tax treatment of bond gains and losses. Many candidates incorrectly assume that the "return of par value" at maturity is tax-free, but any appreciation from discount to par creates a taxable capital gain. This concept appears in tax planning questions, after-tax return calculations, and suitability scenarios involving tax-sensitive clients.
An investor purchases a 10-year corporate bond with a 4% coupon rate at a price of $920. Which of the following statements about this discount bond are accurate?
1. The bond's current yield is higher than its coupon rate
2. The bond will experience price appreciation if held to maturity
3. The investor will receive a tax-free return of principal at maturity
4. The bond's yield to maturity is lower than its current yield
A is correct. Statements 1 and 2 are accurate.
Statement 1 is TRUE: Current Yield = ($40 annual coupon Ć· $920 market price) = 4.35%, which exceeds the 4% coupon rate. This relationship ALWAYS holds for discount bonds because the coupon is calculated on $1,000 par but paid based on a lower market price.
Statement 2 is TRUE: The bond will appreciate from $920 to $1,000 (par value) at maturity, providing $80 in capital appreciation. All discount bonds experience price appreciation as they converge to par.
Statement 3 is FALSE: While the investor does receive the $1,000 par value at maturity (a "return of principal"), the $80 appreciation from $920 to $1,000 is a TAXABLE capital gain. Only the original $920 investment represents a true return of principal. The remaining $80 is taxable appreciation.
Statement 4 is FALSE: For discount bonds, YTM is HIGHER than current yield because YTM includes both the annual coupon income and the annualized capital appreciation to par. The hierarchy is: YTM > CY > Coupon Rate.
The Series 65 exam tests comprehensive understanding of discount bond mechanics, including yield relationships, price behavior, and tax treatment. Questions often present multiple statements requiring you to evaluate each independently. Understanding that discount bonds always follow the YTM > CY > Coupon hierarchy, experience price appreciation to par, and generate taxable capital gains is essential for answering these multi-part questions correctly.
š” Memory Aid
Think "Discount = Deal that gets better": You buy below par and the bond climbs UP to par at maturity (capital appreciation). For yields, remember "YTM Wins" for discount bonds: YTM > Current Yield > Coupon. The YTM is highest because it includes BOTH coupon payments AND the price appreciation to par.
Related Concepts
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