What is an 'Original Issue Discount - OID'
An original issue discount (OID) is the discount from par value at the time a bond or other debt instrument is issued; it is the difference between the stated redemption price at maturity and the actual issue price. The most extreme example of an OID is a zero-coupon bond. Often, the discount offered on a bond inversely correlates with the interest rate associated with the bond; the higher the interest rate, the lower the OID, and vice versa.
BREAKING DOWN 'Original Issue Discount - OID'The OID is the difference between the price a bond is sold at and the bond’s actual face value, also known as par. The OID may be seen as a form of interest, since the buyer receives the face value of the bond even though he paid less than par when it was purchased. In contrast to regular interest rates on a bond, this form of interest is not calculated or paid on a monthly basis. Instead, it is only awarded as a total sum, along with the principal invested, at the time of maturity. These discounts are used to entice buyers into purchasing lower-interest bonds, and may be seen as critical to the successful sale of zero-coupon bonds.
Original Issue Discount and Zero-Coupon Bonds
The highest OIDs are generally offered on zero-coupon bonds, commonly referred to as a zero. These bonds offer no interest. This requires them to be sold well below par, with the investor only realizing any profit or gains when the bond reaches par value at maturity. Since they are not affected by fluctuating interest rates, they are considered low-risk investments, which can make them attractive to more conservative investors. However, zero-coupon bonds are generally not seen as liquid as there is a limited secondary market in which to trade them.
Zero-coupon bonds provide value to their issuing organization as it eliminates the need for interest payments during the life of the bond, trading the costs of management and overhead for the lower initial selling price. Once the bond matures, it may be cashed in for full face value, resulting in profit for the investor and requiring only one additional transaction to complete the process on the end of the issuing entity.
Original Issue Discounts and Tax Liability
Tax liability on an OID bond purchased on the primary market, retained until maturity, and then cashed in is fairly simple to calculate, with the profit counting as either interest or capital gains depending on the exact amount as defined by the IRS tax code.