What is Discount Yield?
The discount yield is a way of calculating a bond’s return when it is sold at a discount to its face value, expressed as a percentage. Discount yield is commonly used to calculate the yield on municipal notes, commercial paper and treasury bills sold at a discount.
Discount yield computes the expected return of a bond purchased at a discount and held until maturity.
Discount yield is computed using a standardized 30-day month and 360-day year.
How is the Discount Yield Calculated?
Discount yield is calculated as follows:
Discount yield = (Face Value – Purchase Price) / Face Value x (360 / No. of Days (or Months) to Maturity)
The components of the discount yield formula are as follows:
- (Face Value – Purchase Price) is the total discount amount applied to the face value of the bond.
- (Face Value – Purchase Price) / Face Value is the percentage value of the total discount on the bond to its face value.
- 360 / No. of Days (or Months) to Maturity is the number of days (or months) remaining until maturity, because the bond is held until maturity.
Limitations to the Discount Yield Measure
Some limitations to the discount yield measure include:
1. Time convention
For simplification of calculation, the discount yield is annualized, taking into account a 360-day year rather than the actual 365-day year. It creates a slight problem because the interest on bonds and Treasury bills is paid on a 365-day basis. The calculation time convention often leads to a mismatch in values.
2. Based on face value
While there is not usually much difference, some mismatch and errors can creep up considering that the discount yield is calculated based on the bond issue’s face value rather than the actual dollar amount invested, i.e., the purchase price.