A bond discount occurs when a bond is issued or traded in the secondary market at a price lower than its face value or par value. The face value is the nominal value of the bond, representing the amount the issuer promises to repay the bondholder at the bond’s maturity. The discount, therefore, is the difference between the face value of the bond and its lower market price.

Here’s how a bond discount works:

1. **Issuance at a Discount:**
– When a bond is initially issued at a price below its face value, it is said to be issued at a discount. Investors are willing to pay less for the bond because the stated interest rate (coupon rate) is lower than the prevailing market interest rates. As a result, the bond’s effective yield is higher than the coupon rate.

2. **Calculation of the Discount:**
– The amount of the discount is calculated as the difference between the face value of the bond and its issue price. For example, if a $1,000 face value bond is issued at $950, the bond is said to have a $50 discount.

\[ \text{Discount} = \text{Face Value} – \text{Issue Price} \]

3. **Amortization of the Discount:**
– When a bond is held until maturity, the issuer may amortize the discount over the life of the bond. This means that a portion of the discount is recognized each year as an adjustment to the interest expense on the income statement. The process ensures that the bond’s book value gradually approaches its face value by the time of maturity.

4. **Recognition of Interest Expense:**
– Even though the bond was sold at a discount, the interest payments to bondholders are typically based on the face value of the bond and the stated coupon rate. The difference between the cash interest payment and the interest expense recognized on the income statement is used to adjust for the amortization of the discount.

Bond discounts are common when market interest rates are higher than the coupon rate offered by the bond. Investors purchasing bonds at a discount have the potential for capital gains if they hold the bond until maturity, as the issuer will repay the full face value at that time. However, it’s essential to consider the overall yield to maturity, which accounts for both the coupon payments and the capital gain or loss at maturity.