Discount notes are short-term debt securities sold for less than their face value, and the gap between what you pay and what you collect at maturity is your entire return. There are no coupon payments and no interest checks along the way. Buy a $10,000 note for $9,800, hold it until it matures, and the issuer sends you $10,000. That $200 difference is the yield, locked in the moment you buy. Maturities run from overnight out to one year, which is why these instruments live in the money market rather than the bond market.
The structure is deliberately simple. The issuer receives cash now and repays a known amount on a set date. You know your exact dollar return from day one, provided you hold to maturity. And because the wait is measured in weeks or months rather than years, the money isn’t tied up for long.
How the Pricing Works
Two rate conventions show up in offering documents and quote screens, and they don’t produce the same number for the same note.
The bank discount rate is the figure quoted most often. It uses a 360-day year and expresses the discount as a percentage of face value. Price equals face value multiplied by one minus the discount rate times days to maturity divided by 360.1TreasuryDirect. Understanding Pricing and Interest Rates A $10,000 note with a 5% discount rate and 90 days to maturity prices at $10,000 × (1 − (0.05 × 90/360)) = $9,875. Your return is $125. The bank discount rate is fine for comparing one discount note to another, but it understates what you’re actually earning because it divides by the face value rather than the smaller price you paid.
The bond equivalent yield, sometimes called the coupon equivalent yield, corrects for both quirks. It uses a 365-day year and divides by the purchase price.2TreasuryDirect. Price, Yield and Rate Calculations for a Treasury Bill For the same note, the bond equivalent yield is ($125 / $9,875) × (365/90) = 5.13%. When you’re stacking a discount note against a CD, a savings account, or anything else quoted on an annual basis, the bond equivalent yield is the honest comparison.
Who Issues Them
Treasury Bills
The most familiar discount notes are Treasury bills, issued by the U.S. Department of the Treasury under its statutory authority to borrow on the credit of the federal government.3Office of the Law Revision Counsel. 31 USC 3104 – Securities Auction and issuance rules sit in federal regulations.4eCFR. 31 CFR Part 356 – Sale and Issue of Marketable Book-Entry Treasury Bills, Notes, and Bonds T-bills come in 4-week, 8-week, 13-week, 17-week, 26-week, and 52-week terms, with most auctioned weekly.5TreasuryDirect. General Auction Timing
T-bills are the accessible option. Minimum purchase is $100, in $100 increments, through the government’s TreasuryDirect platform.6TreasuryDirect. Treasury Bills Backed by the full faith and credit of the federal government, they carry essentially no credit risk and are commonly used as the benchmark for a risk-free return.
Government-Sponsored Enterprise Notes
Freddie Mac, Fannie Mae, and the Federal Home Loan Banks all issue discount notes to fund their operations. Freddie Mac issues them as unsecured general corporate obligations with maturities of one year or less.7Freddie Mac. Short-Term Notes Fannie Mae discount notes start at a $1,000 minimum denomination.8Fannie Mae. Discount Notes Outstanding by Maturity FHLBank discount notes carry a steeper entry point, with a $100,000 minimum and $1,000 increments, and the bulk of trading falls in the one- to 90-day range.
GSE notes are not direct obligations of the federal government, so they carry slightly more credit risk than T-bills and typically pay marginally higher yields. FHLBank discount notes are exempt from state and local income taxes for domestic investors.9FHLBanks Office of Finance. About Discount Notes
Commercial Paper
Corporations issue their own version of discount notes called commercial paper, used to fund short-term operating needs like payroll and inventory. Maturities average about 30 days and can run up to 270 days, which keeps issuance under a Securities Act exemption from SEC registration.10Federal Reserve. Commercial Paper Rates and Outstanding Summary11Office of the Law Revision Counsel. 15 USC 77c – Classes of Securities Under This Subchapter
Commercial paper is largely an institutional product. Minimum denominations are typically $25,000 or more, which puts direct purchases out of reach for most individual investors. Retail exposure usually comes indirectly, through money market mutual funds that pool capital and buy large blocks.
How To Buy Them
Individual investors can buy T-bills directly from the government through TreasuryDirect, which handles all Treasury marketable securities.12TreasuryDirect. Buying a Treasury Marketable Security The retail path uses noncompetitive bidding: you specify the amount you want, up to $10 million per auction, and agree to accept whatever yield the auction produces. You’re guaranteed to receive the full amount you request.13TreasuryDirect. How Auctions Work
You can also buy discount notes on the secondary market through a brokerage. Trades settle on the standard T+1 cycle, meaning the transaction finalizes one business day after the trade.14Financial Industry Regulatory Authority. Understanding Settlement Cycles – What Does T+1 Mean for You Everything is held electronically in book-entry form. Dealers typically embed a markup in the price rather than charging a separate commission, so the cost isn’t always visible on the confirmation. On smaller trades that markup eats into returns more than it does for institutional-sized purchases. For T-bills specifically, buying at auction through TreasuryDirect avoids the dealer markup entirely.
Taxes
The discount you earn on a short-term note is treated as ordinary income, not a capital gain. The IRS requires original issue discount on obligations maturing in one year or less to be reported on Form 1099-INT rather than the Form 1099-OID used for longer-term discounted bonds.15Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID The general OID inclusion rules that apply to longer bonds don’t apply here; short-term instruments fall under a separate framework.16Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
If you use the cash method of accounting, as most individuals do, you generally recognize the income when the note matures or when you sell it, not gradually over its life. Interest income from Treasury securities is exempt from state and local income taxes under federal law, and FHLBank discount notes share that state-tax exemption.9FHLBanks Office of Finance. About Discount Notes Commercial paper and most other corporate discount notes do not; they are fully taxable at every level.
What Can Go Wrong
Credit risk varies with the issuer. T-bills carry essentially none. GSE notes sit in the middle, lacking an explicit government guarantee but widely treated as carrying implicit support. Commercial paper is the riskiest of the three because it is unsecured debt resting on the corporate issuer’s own balance sheet. A company in sudden distress can default. That’s why commercial paper issuers tend to be large, well-rated corporations, and why money market funds that hold it watch issuer quality closely.
Interest rate risk is limited if you hold to maturity, because you receive the full face value no matter what happens to rates in between. If you have to sell early, rising rates will push the note’s market price down. Short-term instruments are far less sensitive to rate moves than longer bonds.17U.S. Securities and Exchange Commission. When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall A 90-day T-bill barely moves when rates shift; a 30-year bond can swing hard.
Reinvestment risk is the flip side of short maturities. Your money comes back quickly, and you may not be able to redeploy it at the same yield. Buy a 13-week bill at 5%, and if rates have fallen to 3% by the time it matures, the next bill you buy will earn less. Anyone using discount notes for steady income should expect the yield to reset frequently.
At Maturity
On the maturity date, the full face value is deposited automatically into your linked bank or brokerage account. There’s nothing to redeem, no forms to file, no action to take. The electronic record updates to reflect the completed obligation. TreasuryDirect holders can set proceeds to roll automatically into a new T-bill at the next auction, which is useful for anyone who wants continuous short-term exposure without repurchasing manually every few weeks.