What Is Accrued Market Discount?
Accrued market discount is the gain in the value of a discount bond expected from holding it for any duration until its maturity. Because discount bonds are sold below face value, it is expected that they will gradually rise in market price until reaching maturity.
Understanding Accrued Market Discount
A bond can be purchased at par, at a premium, or at a discount. Regardless of the purchase price of the bond, however, all bonds mature at par value. The par value is the amount of money that a bond investor will be repaid at maturity. A bond that is purchased at a premium has a value above par. As the bond gets closer to maturity, the value of the bond declines until it is at par on the maturity date. The decrease in value over time is referred to as an amortization of premium.
A bond that is issued at a discount has a value that is less than the par value. As the bond approaches its redemption date, it will increase in value until it converges with the par value at maturity. This gradual increase in value over time is referred to as the accrued market discount. For example, a 3-year bond with a par value of $1,000 is issued at $935. Between issuance and maturity, the value of the bond will increase until it reaches its full par value of $1,000, which is the amount that will be paid to the bondholder at maturity. The difference between the discounted price for which the bond is sold and its face value at maturity ($1,000 - $935 = $65) is the accrued market discount and represents the return on investment to the bondholder.
The accrued market discount is the portion of any price rise caused by the steady increase in bond value. This rise in price is different than that which occurs in regular coupon bonds as a result of lowering interest rates. The accrued market discount may be taxable at the federal, state and/or local level. An investor who chooses to accrue the market discount over the period during which s/he owns the bond would include the amount accrued each year as interest income. Accruing market discount for tax purposes involves increasing the cost basis each year by the amount of the market discount included as income.
An investor also has the option to not accrue market discount for the period s/he held the bond. In this case, if the bond is held to maturity, the difference between the redemption price and the cost basis is added to the bondholder’s income. If the bond is sold before it matures, any gain made from the accretion in bond value is treated as interest income. To put another way, the gain realized on the disposition of a market discount bond must be recognized as interest income to the extent of the accrued market discount, and any remaining gain will be capital if the bond is a capital asset in the hands of the holder.
A taxpayer may elect to determine the accrued market discount under a ratable accrual method or a constant yield method. The constant yield method is the method required by the Internal Revenue Service (IRS) for calculating the adjusted cost basis from the purchase amount to the expected redemption amount. This spreads out the gain over the remaining life of the bond, instead of recognizing the gain in the year of the bond’s redemption.