Discount Note
What Is a Discount Note?
A discount note is a short-term debt obligation issued at a discount to par. Discount notes are like zero-coupon bonds and Treasury bills (T-Bills) and are typically issued by government-sponsored agencies or exceptionally rated corporate borrowers.
Discount notes have maturity dates of as long as one year long. Discount notes don't offer investors periodic interest payments. Instead, investors purchase discount notes at a discounted price and receive the note's face value (likewise called "par value") at maturity.
Understanding a Discount Note
Discount notes are fixed-income securities that don't make interest payments as long as necessary. Since investors don't get the additional advantage of periodic interest income, the notes are offered at a discount to par.
On the maturity date, the notes mature at a par value over the purchase price, and the price appreciation is utilized to calculate the investment's yield. For instance, an investor that purchases a discount note for $9,400 will receive the par value of $10,000 when it matures 90 days from the purchase date. The investor's return on investment (ROI) can be calculated as the difference between the purchase price and face value, that is, $10,000 - $9,400 = $600.
Calculating a Discount Note
The price discount received by the bondholder at maturity can likewise be taken as the imputed interest earned on the bond. To calculate the effective rate earned on the bond, the interest earned can be isolated by the product of the purchase value and time to maturity.
Effective rate = $600/[$9,400 x (90/360)]
Effective rate = 25.53%
Most institutional fixed-income purchasers will compare the yield-to-maturity (YTM) of different zero-coupon debt offerings with standard coupon bonds to find yield pickup in discount bonds.
For tax purposes, any gain produced using the sale or redemption of the discount bond is treated as ordinary income up to the amount of the [ratable share](/ratable-accumulation method) of the bond.
Advantages and Disadvantages of Discount Notes
One of the advantages of discount notes is that they are not as volatile as other debt instruments. They are, therefore, perceived to be a safe investment for investors hoping to preserve their capital in a low-risk investable security.
In addition, these debt instruments are viewed as safe investments due to the fact that they are backed by the full faith and credit of the U.S. government. The risk of default is, thus, negligible. The purchase of discount notes may likewise end up being advantageous for investors who might require access to the funds after a short period of time.
A disadvantage of discount notes is their relatively low ROI. Since they are perceived as safer investments, the amount an investor can earn with them is less compared to other investments. Higher-risk investments have the potential of offering investors a greater profit from a similar principal investment, but they likewise carry a greater risk of loss too.
While the risk of default is negligible with government-issued discount notes, notes issued by corporations have a higher risk of default. Along these lines, corporate notes typically offer investors a higher rate of return compared to government notes.
Special Considerations
The biggest issuers of discount notes are government-sponsored agencies, for example, the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal Home Loan Bank (FHLB). These agencies issue notes to investors as a method for raising short-term capital for different projects.
Discount notes issued by Freddie Mac, for instance, have maturities that reach from overnight to one year. The notes are issued and maintained in book-entry form through the Federal Reserve Bank of New York, and investors might get the notes in denominations as small as $1,000.
Highlights
- Government discount notes are viewed as safe investments since they are backed by the full faith and credit of the United States government.
- The profit the investor earns is the spread between the discounted purchase price of the note and the face value redemption price the investor receives upon the note's maturity.
- Corporations and governments sell discount notes to investors to raise short-term capital for different projects.
- A discount note alludes to a short-term debt obligation normally issued by exceptionally rated corporations or government-sponsored entities.
- Discount notes are issued at a discount to par, and that means investors purchase them at a cost lower than the note's face value.
