bond discount and premium
Imagine a bond promising 5 percent interest, but by the time it goes on sale, new bonds of similar risk are paying 7 percent. No sensible investor would pay full price for the stingier 5 percent bond — they would only buy it at a marked-down price. Flip it around: if the bond pays 8 percent while the market only offers 6 percent, investors will eagerly pay extra for the generous coupon. These markdowns and markups are bond discounts and premiums.
A bond is issued at a discount when investors pay less than its face value, and at a premium when they pay more. The driver is the gap between the coupon rate and the market interest rate at issuance. If the coupon is below the market rate, the bond sells at a discount (price under face value); if the coupon is above the market rate, it sells at a premium (price over face value); if they match, it sells at par. For example, a 1,000 bond might sell for 950 (a 50 discount) or 1,040 (a 40 premium). The company records cash received plus a separate discount or premium account that adjusts bonds payable.
Discounts and premiums matter because they correct the coupon rate to reflect the true cost of borrowing. A discount means the company effectively pays more interest than the coupon suggests (it received less cash but still repays full face value), so the discount is amortized into extra interest expense over the bond's life. A premium means the opposite: the company got extra cash up front, so the premium is amortized to reduce interest expense. By maturity, the discount or premium is fully amortized and the bond's carrying value equals its face value.
A company issues a 1,000 bond with a 5 percent coupon when the market demands 6 percent. Because its coupon is below market, the bond sells for about 960 — a 40 discount. The company records 960 cash, 1,000 of bonds payable, and a 40 discount that will be amortized into interest expense over the bond's life.
Coupon below market means a discount; the discount becomes extra interest expense over time.
A discount does not mean the bond is a bad deal or the company is in trouble — it simply rebalances a below-market coupon, and the issuer's true interest cost ends up equal to the market rate either way.