Original issue discount

What Is Original Issue Discount?

Original issue discount (OID) refers to the difference between a bond's stated redemption price at maturity and its issue price when first sold. It is a form of embedded interest income that arises when a debt instrument is initially issued at a price lower than its face value. This concept is fundamental within the realm of fixed income securities, essentially providing investors with a return through capital appreciation rather than traditional periodic interest payments. Original issue discount is recognized as income over the life of the bond, even if the cash payment is not received until the bond matures.

History and Origin

The concept of original issue discount has been a part of bond markets for decades, evolving alongside the regulatory frameworks designed to address its tax implications. Early debt instruments sometimes featured deep discounts, and the tax treatment for these discounts varied, leading to potential tax avoidance strategies. To prevent such manipulation, the Internal Revenue Service (IRS) began to codify rules requiring the periodic accrual of OID as taxable income for investors, even if no cash was received. A pivotal development in this regard is reflected in publications such as IRS Publication 1212, which guides taxpayers and brokers on identifying and reporting OID instruments. This publication has been updated over the years to reflect changes in tax law and reporting requirements⁸, ⁹.

Key Takeaways

• Original issue discount (OID) is the difference between a bond's face value at maturity and its initial issue price.
• It represents a form of interest income for the investor, realized as the bond's value accretes towards its face value over time.
• OID is generally taxed annually as it accrues, even though the cash payment typically occurs only at maturity.
• Zero-coupon bonds are a common type of debt instrument that always carries an OID.
• Understanding OID is crucial for accurate income reporting and calculating the adjusted basis of an investment.

Formula and Calculation

The fundamental calculation for original issue discount is straightforward:

Where:

• Stated Redemption Price at Maturity: The full face value of the bond that the investor receives at the end of the bond's term.
• Issue Price: The price at which the bond was initially sold to the public.

For tax purposes, the OID is then amortized over the life of the bond using a constant yield to maturity (YTM). This means a portion of the total OID is recognized as income each year.

Interpreting the Original Issue Discount

Original issue discount primarily functions as a yield enhancement mechanism. When a bond is issued with an OID, it means the stated coupon rate might be lower than prevailing market rates, or there might be no coupon at all, as in the case of zero-coupon bonds. The discount compensates the investor for this. From the issuer's perspective, offering a bond at a discount can make the debt financing more attractive to investors, especially if they prefer capital appreciation over periodic interest payments. Investors interpret a higher OID as a greater deferred return built into the bond's structure, which accrues over time through a process known as amortization.

Hypothetical Example

Consider a company issuing a new five-year bond with a face value of $1,000, but it sells the bond for $900. This bond pays no periodic interest.

1. Calculate the OID:
   OID = $1,000 (Stated Redemption Price) - $900 (Issue Price) = $100

2. Annual Accrual (Simplified straight-line for illustration; actual is yield-based):
   If the OID were amortized on a straight-line basis over five years, the investor would recognize $20 ($100 / 5 years) as OID income each year. However, tax rules typically require a constant yield method for accrual.

3. Investor's Experience:
   The investor pays $900 upfront. Each year, they would report a portion of the OID as income on their tax return, even though they receive no cash. At the end of five years, the bond matures, and the investor receives the full $1,000 face value. The $100 difference between the purchase price and redemption price represents their total OID, which has been reported as income over the bond's holding period.

Practical Applications

Original issue discount is prevalent in various financial instruments and markets:

• Zero-Coupon Bonds: These bonds are perhaps the most common example of OID instruments, as they pay no periodic interest and are issued at a deep discount, with the entire return coming from the difference between the purchase price and face value at maturity.
• Structured Products: Some complex debt instrument designs incorporate OID to achieve specific financial outcomes or tax treatments.
• Tax Reporting: Both issuers and bondholders have specific tax reporting requirements related to OID. Issuers of publicly offered OID instruments often report this information to the IRS, and investors typically receive Form 1099-OID detailing the OID amount to include in their taxable income⁶, ⁷.
• Corporate Finance: Companies use bonds with OID as a debt financing tool, especially when current market conditions make traditional coupon bonds less attractive or when they wish to defer cash interest payments.
• Public Offerings and Private Placements: OID instruments can be issued through public offerings or as private placement securities. Recent market activities show continued interest in OID products, such as callable zero-coupon notes, by public sector entities seeking cost-effective funding⁵. Conversely, sometimes state-run firms delay issuance of zero-coupon bonds due to weak investor demand⁴.

Limitations and Criticisms

While original issue discount offers certain benefits, particularly for issuers, it comes with limitations and criticisms for investors:

• Phantom Income: The most significant drawback for investors is the "phantom income" aspect. Investors must pay taxes on the accrued OID annually as taxable income, even though they do not receive any cash payments until the bond's maturity³. This can create liquidity challenges for investors who may need to sell other assets to cover their tax liability.
• Interest Rate Sensitivity: Like all fixed-income securities, bonds with OID are sensitive to changes in interest rates. An increase in prevailing interest rates can cause the market value of existing OID bonds to fall, leading to potential capital gain or loss if sold on the secondary market before maturity.
• Complexity: The calculation and reporting of OID, especially for bonds purchased in the secondary market at a premium or discount to their adjusted issue price, can be complex, requiring careful attention to IRS rules and guidance from publications like IRS Publication 1212².
• Default Risk: A significant original issue discount, particularly on bonds that also pay periodic interest, could sometimes indicate an issuer facing financial difficulty. Investors might demand a deeper discount to compensate for higher perceived default risk.

Original Issue Discount vs. Zero-Coupon Bond

While often used interchangeably, "original issue discount" and "zero-coupon bond" are related but distinct concepts.

All zero-coupon bonds inherently have an original issue discount because their return is entirely derived from the difference between their purchase price and their face value at maturity. However, not all bonds with an original issue discount are zero-coupon bonds. A regular bond that pays a low coupon rate might also be issued at a discount, thereby having an OID in addition to its periodic interest payments. The key distinction lies in the presence or absence of stated periodic interest payments.

FAQs

What types of debt instruments typically have an original issue discount?

Original issue discount is most commonly found in zero-coupon bonds, which pay no periodic interest. However, it can also apply to other debt instruments, such as certain corporate or government bonds, municipal bonds, or certificates of deposit, if they are initially issued at a price below their face value.

Why would a bond be issued with an original issue discount?

Bonds are issued with an original issue discount primarily to make them more attractive to investors. This can happen if the bond's stated coupon rate is lower than the prevailing market interest rates, or if the issuer wants to defer cash interest payments. The discount compensates investors by promising a higher effective yield over the bond's life.

Do I have to pay taxes on original issue discount every year?

Yes, generally, investors are required to include a portion of the original issue discount in their taxable income each year as it accrues, even if they do not receive any cash payments until the bond matures. This is often referred to as "phantom income" because tax is due on income not yet received. The IRS provides guidance on how to calculate and report OID income¹.

How does original issue discount affect the bond's basis?

As the original issue discount accrues and is included in your income, it increases your adjusted basis in the bond. This increase in basis helps prevent double taxation. When you sell the bond or it matures, this adjusted basis reduces your potential capital gain or increases your capital loss.

Can an original issue discount be "de minimis"?

Yes, the IRS has a "de minimis" rule for original issue discount. If the total OID on a debt instrument is less than a specified threshold (one-fourth of one percent of the stated redemption price at maturity multiplied by the number of full years to maturity), it can be treated as zero for tax purposes. This means the discount may not need to be accrued annually and would instead be treated as capital gain when the bond is sold or matures.