Discount Yield Formula, Meaning and Examples

The discount yield is a financial metric used to calculate the annual rate of return on a bond when it is sold at a discount to its face value. It is expressed as a percentage and is particularly useful for short-term bonds and treasury bills. Here's a detailed look at how to calculate and use discount yields: 1. **Understanding Discount Yield**: - Discount yield is the expected annual percentage rate of return earned on a bond when it is sold at a discount on its face value. - It is also known as the bank discount yield (BDY) and is commonly used for municipal bonds, treasury bills, zero-coupon bonds, and commercial paper. 2. **Calculating Discount Yield**: - The formula for calculating discount yield is: \((\text{Face Value} - \text{Purchase Price}) / \text{Face Value} \times 360 / \text{Number of Days to Maturity}\). - It is important to use a 30-day month and a 360-day year to simplify the calculation. 3. **Using Discount Yield**: - Discount yield is used to calculate the yield on bonds held until maturity, where the return on investment (ROI) is determined by the yield computation of the discount bond. - It is different from bond accretion, which is used for bonds issued at a premium or discount, where the discount amount is posted to bond income over the life of the bond. 4. **Practical Applications**: - Municipal bonds are low-risk debt securities issued by the government, primarily to finance public expenditures. These are exempt from most federal and provincial taxes. - Treasury bills are low-risk debt securities issued by the U.S. government, with a short term maturity of one year or less. While the interest income earned from T-bills is subject to federal income tax policies, it is exempt from most state and local taxes. - Zero-coupon bonds are sold at a significant discount from their face value, ultimately rendering a profit at maturity to the bondholder. In conclusion, discount yield is a valuable tool for investors to assess the rate of return on bonds sold at a discount. It provides a clear method to calculate the annualized return based on the discount amount, face value, and time to maturity. This calculation is essential for investors making investment decisions, especially in short-term bonds and treasury bills.