Posted by Aurelia E Weems CPA

Original Issue Discount (OID)

Original Issue Discount (OID)

Original issue discount (OID) occurs when companies sell securities at a reduced price. Sometimes bonds are sold at a value lower than the value declared at maturity; the difference is the OID, which is converted into additional accrued interest income for the buyer if maintained until maturity.


Key Points to Note

  • The OID is the difference between the value of the original face value and the discount price paid for a guarantee.

  • OID bonds have the potential for profit because investors can buy them at a price below their nominal value.

  • OID securities sold at a discount may indicate that an issuer is in financial difficulty and that this model is possible.

 

In-depth Explanation

When interest rates are high, companies wishing to sell bonds can keep high-interest payments for the duration of the loan. Interest rates will eventually decline, and longer-term securities can potentially overwhelm the issuer's cash flow with payments above the market level. The sale of long-term bonds, discount coupons, or zero discounts solves this problem.

There are two types of OID bonds: those with coupons and those without. OID bonds that include a coupon offer investors regular interest payments, but their price is lower than that of the securities' face value. Non-coupon OIDs are called zero-coupon bonds, and the reduction is generally equal to the yield to maturity or the amount that would have been paid in interest during the interest-bearing bond.

From the owner's perspective, an OID bond offers higher profits with less investment. Some OID investors reinvest coupon payments at a discount from the highest interest rates, further increasing their returns. For retirement planning, OID zero-coupon bonds offer a great way for cardholders who don't need regular interest payments to earn more income at maturity.

Bonds are considered to be one of the safest parts of a portfolio. But are they a haven for investors? 


OID and Interest Rate

A business may have a bond that is sold at a nominal value discount and pays periodic interest. However, the OID value tends to be inversely related to the interest rate of the collateral. In other words, the higher the discount, the lower the coupon rate offered in the security.

The logic behind the negative correlation is that companies can issue a guarantee with a reduction in nominal value so that the company does not have to pay investors a regular and continuous interest rate. Although interest in security is a recipe for investors, it is an expense for businesses. 

On the other hand, the higher the rate of a bond, the less it is likely to be sold at a discount, and its OID, if any, would be lower. If the bond rate is attractive to investors, there will likely be many buyers and demand for bonds, so it is unlikely to be sold at a huge discount.

Investors should understand this simply because purchasing a coupon does not mean that it is a real deal. The return received from the OID may be lower than the interest rate offered for a traditional fixed-rate bond. The comparison is important because the reduction in the initial issue, the more the total regular coupon payments must be higher than the fixed-rate products, to make it a bargain.


Initial Issue Discounts and Zero-Coupon Bonds

The securities with the largest initial issue discount are generally zero-coupon bonds. As the name suggests, these debt securities do not pay interest on the coupons. Without attracting buyers, they must offer higher discounts than bonds that pay interest and are sold at face value. The only feasible way for investors to earn from a zero-coupon bond is the difference amid the bond's purchase price and the face value at maturity. 

Zero-coupon bonds save the issuer the cost of interest payments at the lowest initial selling price. Once the bonds are reduced, they are exchanged for their total nominal value.

Because they do not pay coupons, zero-coupon bonds are not affected by fluctuations in interest rates. In general, if interest rates rise significantly, existing fixed-rate bonds become less attractive, and their prices fall when investors sell them elsewhere for higher rate bonds. Alternatively, if interest rates fall significantly, existing fixed-rate bonds become more attractive, and their prices rise when investors rush to buy them.

Without the impact of changes in market interest rates, some believe that these investments present a low risk. However, zero-coupon bonds are usually not as liquid, so there will be few buyers and sellers in the secondary bond market. 


Original Issue Discounts and Default Risk

Just as you have to examine an old TV set selling for a discount for flaws, you must also be careful with the right OIDs. A high OID could sell at a discount because the bond issuer is experiencing financial difficulties. Also, a sale of discounted securities can lead to a shortage of investors willing to buy it for certain reasons. It can be expected that the company will not pay the guarantee. One implication is when an issuer can no longer make interest payments or repay the principal amount that bondholders initially invested.

If corporate bonds fail, investors have few resources. Although bondholders are paid before ordinary shareholders in the event of bankruptcy, there is no guarantee that the investor will receive, if applicable, a return on the total value of his investment.

Although investors are somewhat compensated for their risk by buying stocks at a reduced price, they should weigh the risks against the rewards.


Pros

  • Investors pay less than the face value of an OID bond.

  • OID liabilities are less affected by changes in interest rates.

  • Zero-coupon bonds use large OIDs to attract investors.

Cons

  • Discount bonds may indicate that an issuer is experiencing financial difficulties.

  • Investors may be subject to an annual tax obligation before the maturity of the bond.

  • The OID cannot offset the costs offered by traditional fixed-rate bonds.


Original Issue Discounts and Tax Liability

Investors must contact a tax professional or consult the IRS tax number before investing in securities considered an original issue discount. The difference between the reduced purchase price and the nominal value may be taxable. However, investors may be required to report a portion of the income earned each year from holding the collateral, even if they have not received a nominal value at maturity.



Aurelia E Weems CPA
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