Posted by The TaxAdvocate Group, LLC

Understanding Original Interest Discount and all it Entails

Understanding Original Interest Discount and all it Entails

We explain the original issue discount as the discount in price from the face value of a bond at the time it was first issued. Bonds can be issued at a price lower compared to their face value, called the discount. The original issue discount is the difference between the bond price and the relationship's face value.

Bond issuers use original issue discounts to lure buyers into buying their bonds to raise money for their business.

When the bond is purchased, the issuer must pay the bondholder an interest called a coupon. At the interval, the bondholder gets interest, depending on the bond rate. On getting to maturity, the investor will get the return of the bond face value.

There are some bonds; however, that sell for less than the face value. The OID is the difference between the bond price and its face value. This might be considered as interest because the buyer gets the face value of the bond when it matures though the purchasing power is lower than the face value.

OIDs and Interest Rates

A firm can give out a bond at a discount to the face value while paying periodic interest. What the OID is, however, does correlate inversely with the interest rate on the bond. As a result, the more discount, the lesser the coupon given out on the bond.

What causes the negative correlation is that companies might give out a bond at a discount to its face value. With this, the company will not give a regular and ongoing higher interest rate to the investors. While investors get interest on their bond, it is expenditure for the company.

On the other hand, the more the bond rate, the lower the tendency of selling at a discount. This will result in a smaller OID if any. If the bond rate attracts investors, the buyers and demand for the bond will increase; hence there might not be many discounts.

Original Issue Discount and Zero-Coupon Bonds

The bonds with more original issue discounts are zero-coupon bonds. You will not get a coupon interest with these debt facilities. If this is not an incentive to buyers, there must be deeper discounts when compared to bonds giving interest and selling at face value. Investors can only earn from a zero-coupon bond from what they get when they subtract the purchase price and face value at maturity.

Since no coupons are paid, interest rate fluctuation does not affect zero-coupon bonds. With this, a rise in the interest rate fixed-rate bonds will no longer be enticing. This will trigger a lower price as investors sell them for a higher rate. The same holds for the opposite.

Original Issue Discounts and Default Risk

In the same way, you need to consider a better selling price for discount flaws; you should also take the same care with OID bonds. Anyone selling a large OID could be giving it out at a discount due to the bond issuer's financial distress. The discount sale could also point out the lack of investors that could be interested in it for any reason. They could think the company might not be faithful to the bond (In a case when they can't make an interest payment or repay the principal amount again).

The defaulting of the corporate bond comes with little recourse for investors. While bondholders get paid before stockholders should there be bankruptcy, there is no assurance that the full amount will be paid.

While investors get some form of compensation for the risk of buying the bond at a discounted price, it is essential to consider the pros and cons.

Original Issue Discounts and Tax Liability

As an investor, it is an excellent move to get in touch with tax professionals or peruse the IRS tax code if they plan to invest in bonds called original issue discounts. The difference between the discounted price and face value might be taxable. Investors, however, need to make available part of their income they earn every year they hold the bond. The fact that they do not have the face value amount does not matter.

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