A discount bond is any bond that trades for less than its face value (also called par value), which is the amount the issuer pays back when the bond matures. If a bond has a face value of $1,000 and you buy it for $950, you’re holding a discount bond. That $50 gap between what you paid and what you’ll receive at maturity is part of your return, on top of any interest payments the bond makes along the way.
Why Bonds Trade at a Discount
The most common reason a bond ends up priced below par is a shift in market interest rates. Bond prices and interest rates move in opposite directions. When rates rise, existing bonds with lower coupon rates become less attractive compared to newly issued bonds paying higher rates. To compensate, the older bond’s price drops until its effective yield matches what buyers can get elsewhere.
Here’s a concrete example. Suppose you own a bond paying a 3% coupon. If new Treasury bonds start offering 4%, nobody will pay full price for your 3% bond. Its market price falls until the combination of coupon payments and the discount brings the total return roughly in line with 4%. The SEC notes that bonds with lower coupon rates generally experience larger price drops when market rates rise, since a greater share of their return depends on that fixed coupon.
Credit quality can also push a bond into discount territory. If the issuer’s financial health deteriorates or its credit rating is downgraded, investors demand a higher yield to compensate for the added risk. Since the coupon rate is locked in, the only way the yield can increase is for the price to fall.
How Your Return Works
When you buy a discount bond, your total return comes from two sources: the periodic coupon payments you collect while holding the bond, and the capital appreciation as the bond’s price rises toward par at maturity. A bond purchased for $950 with a $1,000 face value delivers $50 in built-in price gain if you hold it to maturity, plus whatever coupon income it pays along the way.
The standard way to measure what you’ll earn is yield to maturity, or YTM. This is the annualized rate of return you’d get if you hold the bond until it matures and reinvest every coupon payment at the same rate. YTM accounts for the bond’s current price, its face value, the coupon rate, and the time remaining until maturity. For a discount bond, YTM is always higher than the coupon rate, because the discount itself adds to your return. A quick approximation:
YTM = [Annual Coupon + (Face Value − Current Price) ÷ Years to Maturity] ÷ [(Face Value + Current Price) ÷ 2]
For a $1,000 bond with a 3% coupon ($30 per year), bought at $950 with 10 years left, that works out to roughly 3.59%. The coupon alone only pays 3%, but the $50 gain spread over a decade pushes the effective yield higher.
Bonds Issued at a Discount
Some bonds don’t just fall to a discount in the secondary market. They’re designed to sell below par from the start. The clearest examples are zero-coupon bonds, which make no periodic interest payments at all. You buy them at a discount, and your entire return comes from the difference between what you paid and the face value you receive at maturity.
Treasury bills work this way. These are short-term government securities that mature in one year or less, sold at a discount to face value. TreasuryDirect explains the math simply: the gap between the discounted price you pay and the face value you receive is your interest. If you buy a $10,000 T-bill for $9,800 and receive $10,000 at maturity, that $200 difference is your earnings.
STRIPS are another example. These are created when market participants take a regular Treasury note or bond and separate each interest payment and the final principal payment into individual zero-coupon securities. A single 10-year Treasury note with semiannual coupons can be broken into 21 separate STRIPS: 20 from the interest payments and one from the principal. Each one sells at a discount and pays its face value on its specific date.
How Discount Bonds Are Taxed
Tax treatment depends on whether the bond was originally issued at a discount or fell to a discount later in the open market.
Original Issue Discount (OID)
When a bond is issued below par, the IRS calls the difference between par and the issue price “original issue discount.” The key rule: you owe income tax on OID as it accrues each year, even if you don’t receive any cash. For a zero-coupon bond you hold for 20 years, you’ll report a portion of the discount as taxable interest every single year, not just when you finally get paid at maturity. You report this on the interest line of your Form 1040, and your broker will typically send you a Form 1099-OID showing the amount.
There is a de minimis exception. If the total OID is less than 0.25% of the face value multiplied by the number of full years to maturity, you can treat it as zero. For a 10-year bond with a $1,000 face value, the threshold is $25 (0.0025 × $1,000 × 10). Below that amount, you don’t need to accrue OID annually.
A few categories are exempt from the annual accrual rules: U.S. savings bonds, tax-exempt obligations like municipal bonds, and personal loans under $10,000 between individuals who aren’t in the lending business.
When you eventually sell or redeem an OID bond, your cost basis has been increasing each year by the OID you reported. That higher basis reduces your capital gain (or increases your loss) at the time of sale. Any resulting gain or loss is generally treated as a capital gain or loss if you held the bond as an investment.
Market Discount
If a bond was issued at or near par but you bought it later at a discount because its price dropped, that’s market discount rather than OID. The tax rules differ. You can choose to accrue the market discount annually (similar to OID), or you can defer it until you sell or redeem the bond. If you defer, the gain attributable to the accrued market discount is taxed as ordinary income, not as a capital gain. This distinction matters because ordinary income tax rates are typically higher than long-term capital gains rates.
What Discount Bonds Mean for Investors
Buying bonds at a discount can be appealing because the built-in price appreciation adds to your yield. But the trade-offs depend on your situation. If you’re in a taxable account and buying OID bonds, the annual tax on “phantom income” you haven’t actually received in cash can be a drag, especially with zero-coupon bonds where no cash arrives until maturity. Holding OID bonds in a tax-deferred account like an IRA sidesteps that issue.
Discount bonds also carry reinvestment risk in reverse. With a zero-coupon bond, there are no coupons to reinvest, which means you’ve effectively locked in your yield to maturity from day one. That’s an advantage when rates are falling, since you won’t be forced to reinvest at lower rates, but it’s a disadvantage if rates climb further.
The price of a discount bond naturally drifts toward par as maturity approaches, a process sometimes called “pull to par.” This means that if you buy a discount bond and hold it to maturity, the market price fluctuations along the way are less relevant to your actual return. For investors focused on predictable outcomes rather than trading gains, that steady convergence toward face value is one of the most straightforward features of discount bonds.