Market Discount (Bonds) - Explained
What is a Market Discount?
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Table of ContentsWhat is a Market Discount on Bonds?How Does a Market Discount on Bonds Work?Example of Market Discount in BondsMarket Discount ExemptionsAbout Market Discount Bonds
What is a Market Discount on Bonds?
Market discount refers to the difference between the specified redemption price of a bond and its secondary market purchase price, specifically when the purchase price at the time was below par. It can also be defined as any given bond with a market discount.
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How Does a Market Discount on Bonds Work?
Market discount happens when there is a decrease in the value of the bond on a secondary market following an increase in the interest rates after being issued. Note that there is no annual taxation on bond when it comes to market discount in the United States. However, if in a particular year a bond is redeemed or sold, then it can be taxed as ordinary interest income. On the other hand, the bond investor can as well decide to include an annual amortized market discount for the purpose of taxing. However, this kind of tax is paid in the current period instead of doing it in the future. Also, even though there is tax exemption when it comes to the regular bonds return, it can still be subject to taxation in given situations like that of municipal securities.
In the secondary market bond, the movement of the bonds price is opposite to that of the interest rates. This means that the outstanding bonds value will drop when there is a rise in interest rates. The reason behind this is that the payment of coupons is high when it comes to new bonds. This then means that the current bonds price has to be adjusted for it to trade at a similar yield.
Example of Market Discount in Bonds
Lets assume that an investor from the United States pays $10,000 for a bond issue whose par value is $12,000. In this case, the market discount will be the difference an investor gets when he or she subtracts the purchase price from the par value which in this case will be $200 ($1,200 - $1,000 = $200). Note that the difference is supposed to be reported on the tax return of an investor as ordinary interest income. This can be done after the disposition or on an annual amortized basis.
Market Discount Exemptions
There are various exemptions when it comes to the election rule. For instance, there is an exception for United States savings bonds and also for short-term bonds that mature either before the date which the bond was issued or mature in one year. Also, there is an exemption depending on how the market discount is handled for the purpose of taxation, in relation to small market discounts (de minims). According to de minims, when the purchase discount amount is below 0.25% of the bonds face value, then the market discount is taken to be zero. This is then calculated by multiplying it with the number of years starting from the date the bond was acquired (purchased) to the bonds maturity date. However, if the market discount happens to be below the de minims amount upon selling or redeeming the bond, then the market discount is taken to be a capital gain and not an ordinary income.
About Market Discount Bonds
Note that the term bond may refer to any type of bond such as debenture, certificate, note, among other evident indebtedness. Basically, market discount related bonds are not applicable to those bonds which have been acquired at their initial issue. Also, Market discount bonds do not include the following:
- Short term obligations (bonds that mature in one year after it has been issued)
- Installment obligations as stipulated in Sec. 453B (3) United States savings bonds
- Tax-exempt bonds that are acquired before May 1, 1993 (Sec. 1278).