Original Issue Discount - Explained
What is an Original Issue Discount?
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Table of ContentsWhat is an Original Issue Discount?How Does an Original Issue Discount Work?KEY TAKEAWAYSOriginal Issue Discounts and Interest RatesOriginal Issue Discount and Zero-Coupon BondsOriginal Issue Discounts and Tax LiabilityOriginal Issue Discounts and Default RiskProsReal World Example of an Original Issue Discount
What is an Original Issue Discount?
An original issue discount (OID) is when the companies sell their face value bonds at a discount. Often bonds are sold at maturity for a sum less than their stated value; the difference is the OID, which becomes the buyer's additional interest income if it retains it at maturity. Original issue discount applies to a debt instrument that was originally sold at a price significantly below its face value (i.e., at a deep discount). OID is generally generated when a debt is generated at a discount, usually a bond. In fact, the sale of a debt at a discount transforms an asset into a return on investment or interest.
How Does an Original Issue Discount Work?
There are different forms of debt instruments. A debt instrument arrangement or deal between the lender, the party lending money, and the creditor, the party borrowing money. The debt instrument enables the lender to lend money to the borrower who promises to repay the loan. Common types of debt instruments include mortgages, loans, bonds, leases, and notes. In general, a debt instrument has OID when the instrument is released at maturity for a price less than its claimed redeeming amount. OID bond investors receive a financial statement from the issuers, detailing interest income on discount issues. These bonds basically mature in more than one year. Bond issuers use OID to encourage buyers to buy their bonds to raise money for their enterprise.
- An original issue discount (OID) is when the companies sell their face value bonds at a discount.
- OID bonds may have benefits because buyers may buy bonds for less than their face value at a lower price.
- When a bond is willing to offer an enormous OID, it may sell at discount because of the financial distress of the bond issuer. It could also be selling at an enormous OID due to a lack of investors ready to buy the bond or a notion that the company could default on the bond.
- Deeply discounted OID bonds on the secondary market can be more difficult to sell.
- Profoundly priced OID offer opportunities to match assets against liabilities.
Original Issue Discounts and Interest Rates
A business may have a bond that while paying interest, sells at a discount on its face value. The sum of OID, however, tends to correspond inversely with the bond rate's interest rate. In simple terms, the higher the discount, the lower the bond rate. On the other hand, the higher the bond rates, the lower the chance that it will sell at a reduced price and the smaller its OID. If the cost of a bond is appealing for investors, the demand for the bond would definitely be purchased. It doesn't mean that investors got a better deal than they could have gotten if they had bought a traditional fixed-rate bond just because of a bond trades for a discount.
Original Issue Discount and Zero-Coupon Bonds
Zero-coupon bonds are defined as bonds that have the highest original issue discounts. Investors make a profit or the OID only when the bond matures and pay the bond's face value. Investors are generally attracted to Zero-coupon bonds due to the fact that fluctuations in interest rates have no effect on them. In normal situations, though interest rates are rising considerably, current fixed-rate bonds are declining, and their values are decreasing as investors sell them elsewhere for higher rates bonds. Since zero-coupon bonds don't pay interest, they are considered as low-risk investments because interest rate movements are not affected. Zero-coupon bonds are not, however, considered as a liquid, so that only limited buyers and sellers can trade them.
Original Issue Discounts and Tax Liability
The handling of an original issue discount is having major tax consequences. These consequences are often perceived as the major drawbacks to investing in OIDs. The portion of interest returned upon maturity is effectively incorporated into the price calculations of the bond. In other words, the rebate is recouped over the bond's lifetime. This recouped value is then required for tax purposes to be declared by investors, resulting in annual tax due even if payment is received only after maturity. It is therefore, necessary for investors to consult a tax expert or check the IRS tax code before investing in bonds that are deemed discounts for the original issue.
Original Issue Discounts and Default Risk
A situation where an issuer can no longer make interest payments or recover the amount of principal originally paid by the bondholders is known as a default. When a bond is willing to offer an enormous OID, it may sell at discount because of the financial distress of the bond issuer. It could also be selling at an enormous OID due to a lack of investors ready to buy the bond or a notion that the company could default on the bond. While in the case of bankruptcy a company pays bondholders out before common stockholders, bondholders might not, if anything, be paid for the full amount of the investment.
- Higher return: For those bonds, at least in respect of low OIDs, the market generally requires higher (and sometimes significantly higher) returns compared with higher specified bonds with the same maturity and no OID
- Asset/Liability Matching: Profoundly priced OID offer opportunities to match assets against liabilities.
- The price impact of decreases in market interest rates: The amount of OID that accrues from one compounding date to the next compounding date but is not paid is, in essence, immediately reinvested in the same bond at the same yield as the original investment at the end of the compounding period. When market interest rates decline, the automatic reinvestment causes the OID bond to rise in value more rapidly than its counterpart.
- Lack of cash flow to pay taxes: If interest on an OID bond is taxable for normal federal, state or local income tax purposes or is tax-exempt for federal income tax purposes but taken into account for alternative minimum tax purposes, the bondholder would be liable to pay the OID tax with no cash receipts or minimum receipts from a deeply discounted OID bond.
- Low liquidity: Deeply discounted OID bonds on the secondary market can be more difficult to sell.
- Greater Exposure to Market Discount Rules: OID bonds won't have the degree of protection from the implementation of the market discount rules given for bonds classified as bought at par or premium under the De Minimis Market Discount Rule.
Real World Example of an Original Issue Discount
For example, assume a 20-year face value zero of $10,000 is issued in the market by Issuer X that demands a maturity yield of 7%, compounded semi-annually. Its price would be par 0.2526, or $2.526, plus commission. Purchasing investors at that price can lock up a compound interest rate of 7% regardless of what happens to market rates until the bond matures. Due to the Original Issue Discount's price volatility, if interest rates were to increase to 8% at the end of the first year, the bond would fall to $2,253 or -16.7% in value.