A market discount is the difference that occurs when a debt instrument has decreased in purchase price since the time of its original issue. Market discounts sometimes involve factors like a shift in the interest rate that applies to the debt instrument, as well as any change in the original issue discount, or OID. This can lead to a situation where the debt instrument is sold for less than face value, especially when the sale takes place before the instrument reaches maturity.
The best way to understand a market discount is to consider the purchase of a bond or other debt instrument with an original issue discount. Bonds of this type do not include a stated rate of interest in the terms of the purchase, and pay interest at current rates only upon maturity. Zero coupon bonds are a good example of this type of OID arrangement.
With a zero coupon bond, a market discount occurs if the bond demonstrates an adjusted basis immediately after acquisition. Assuming that the adjustment renders the issue price plus any original issue discount that is accrued prior to the purchase to be more than the purchase price, the investor stands to earn a higher return than originally anticipated. This particularly true if interest rates hold for the life of the bond, and the investor chooses to retain ownership of the bond all the way to maturity.
For example, an investor purchases a discount bond that has a par value of $2,000.00 in United States dollars. The purchase price is set at $1,500.00 USD. If the investor chooses to hold onto the bond until maturity, there is a gain of $500.00 USD. In the event that any interest is also applied to the bond at the point of maturity, the investor also earns that rate of interest from the date of acquisition to the date of maturation. This difference is often referred to as an accrued market discount, since the appreciation accrues over the life of the bond.
Since bonds are considered one of the relatively safe forms of investment, many conservative investors actively look for bond issues that are likely to generate a market discount. This type of situation can take place with bonds that mature in as little as two years, or take as long as twenty years to reach maturity. As with any type of investment activity, the investor is free to sell the bond at any time, although this often means realizing less of a market discount than if the bond were held all the way to maturity.
