Market Discount

What Is a Market Discount?

A market discount is the difference between an asset's stated redemption price and its lower price in the secondary market. For a fixed-income security, a market discount would exist if it trades below par value. Market discounts arise when the asset's value on the secondary market decreases after it has been issued, usually because of a rise in interest rates—but a discount may also manifest as the result from a reduction in credit rating, increase in perceived risk, or regulatory or legal action that impacts that asset.

In the case of original issue discount (OID) securities such as zero-coupon bonds, the market discount is the initial difference between the purchase price and the issue price plus accrued OID.

Understanding Market Discounts

While any asset or security can trade at a market discount, the term most often applies to fixed-income securities, and especially to bonds. A bond sold at par (also called face value) has its coupon rate equal to the prevailing interest rate in the economy. An investor who purchases this bond has a return on investment that is determined by the periodic coupon payments. The bond discount is the difference by which a bond's market price is lower than its face value.

A premium bond is one for which the market price of the bond is higher than the face value. If the bond's stated interest rate is greater than those expected by the current bond market, this bond will be an attractive option for investors.

A bond issued at a discount has its market price below the face value, creating the potential for capital appreciation upon maturity since the higher face value is paid when the bond matures.

Taxes and Discounts

A market discount on a bond is not subject to taxation annually in the U.S., but it is taxable as ordinary interest income in the year that the bond is sold or redeemed. The bond investor can also elect to include amortized market discount annually in income for tax purposes, although this would mean paying tax on it now rather than in the future. Note that market discount is taxable even if regular interest income from the bond in question is tax-exempt like it is for municipal securities.

For instance, assume that a U.S. investor pays $900 for a bond that was originally issued with a par value of $1,000. The $100 difference between the par value and the purchase price is the market discount. This difference will have to be reported as ordinary interest income on the investor’s tax return either upon disposition or annually on an amortized basis, depending on the election made by the investor.

Special Considerations

There are certain exceptions to the election rules, such as for U.S. savings bonds and for short-term obligations that mature in one year or less from the date of issue. Also, for tax-exempt bonds purchased before May 1, 1993, a gain arising from a market discount is treated as a capital gain rather than interest income.

Another exemption to the election of how market discount should be treated for tax purposes relates to "de minimis" or small market discounts. Under the de minimis rule, the market discount is treated as effectively zero if the amount of the discount upon purchase is less than 0.25% of the bond's face value, multiplied by the number of full years from the time of purchase to the maturity date. If the market discount is less than the de minimis amount, the market discount would have to be treated as a capital gain—rather than ordinary income—when the bond is sold or redeemed.

As an example, if you buy a $1,000 par value bond maturing in 10 years for $985, the market discount is $1,000 - $985 = $15. Since this discount is less than the de minimis threshold of $25 (0.25% of $1,000 x 10 = $25), the market discount is considered to be zero. As a result, the $15 discount will be treated as a capital gain when you sell or redeem the bond.