When a bond is sold at a discount, how does its interest rate compare to market interest rates?

When a bond is sold at a discount, it means that its selling price is lower than its face value. The interest rate on this bond, commonly referred to as the coupon rate, is fixed at issuance. However, the actual yield that an investor receives from the bond is not simply determined by the coupon rate; it also takes into account the price paid for the bond.

In the scenario of a discount bond, the investor will receive the full face value at maturity, which means they will make a profit on the principal amount invested. This results in a higher effective yield compared to the fixed coupon rate, especially since the investor pays less than the face value of the bond. Consequently, the interest rate associated with this bond, when calculated as a yield to maturity, will be higher than prevailing market interest rates.

This situation arises because when market interest rates rise, existing bonds with lower coupon rates become less attractive, causing those bonds to sell at a discount. Therefore, for newly issued or existing bonds with coupon rates that do not align with higher market rates, investors require a greater yield to compensate for the reduced market value of the bond. Thus, a bond sold at a discount has a higher interest rate relative to the current market rates.