What Is an Original Issue Discount?

An original issue discount (OID) is the discount in price from a bond's face value at the time a bond or other debt instrument is first issued. Bonds can be issued at a price lower than their face value—known as a discount. The OID is the amount of discount or the difference between the original face value and the price paid for the bond.

Original issue discounts are used by bond issuers to attract buyers to purchase their bonds so that the issuers can raise funds for their business. Many zero-coupon bonds use large OIDs to entice buyers to their products.

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Original Issue Discount

Key Takeaways

  • The original issue discount (OID) is the difference between the original face value amount and the discounted price paid for a bond.
  • OID bonds have the potential for gains since investors can buy the bonds for a lower price than their face value.
  • OID bonds sold at a discount could indicate an issuer is facing financial difficulty and default is possible.

Understanding Original Issue Discounts

Once purchased, the bond's issuer usually pays the bondholder an interest rate—called a coupon—while the investor holds the bond. Periodically, the bondholder receives interest payments based on the rate of the bond. When the bond reaches maturity, the investor gets the return of the face value paid for the bond.

However, some bonds sell for a price less than the face or par value of the note. The OID is the difference between the price paid for a bond and its face value. The OID may be considered interest since the buyer is paid the face value of the bond at maturity even though the purchase price was lower than the face value.

For example, say a bond that has a $100 face value, and normally, the investor receives the return of the $100 at its maturity. If the investor buys the bond for $95 and receives $100 at maturity, the OID is $5 or the return on the investment.

As opposed to traditional bonds, the gain from the OID is only realized at maturity when the investor receives the return of the face value principal. In other words, the OID is paid as a total sum at maturity, along with the original amount invested.

OIDs and Interest Rates

A company can have a bond that sells at a discount to its face value while it also pays periodic interest. However, the amount of OID tends to correlate with the interest rate on the bond inversely. In other words, the bigger the discount, the lower the coupon rate offered on the bond.

The reason for the negative correlation is that companies might issue a bond at a discount to its face value, so the company does not have to pay a regular, and ongoing higher interest rate to investors. Although interest earned on a bond is income for investors, it's an expense for companies.

Conversely, the higher the rate on a bond, the less it is likely to sell at a discount, and its OID, if any, would be smaller. If a bond's rate is attractive to investors, there will likely be many buyers and demand for the bond, so it's not likely it will sell for much of a discount.

Investors should understand that just because they are buying a bond at a discount, it does not mean it is a bargain. The return received for the OID may end up being less than the interest rate offered on a traditional fixed-rate bond. Comparison is important as the original issue discount plus the total of regular coupon payments must be higher than alternative fixed-rate products to make it a bargain.

Original Issue Discount and Zero-Coupon Bonds

The bonds with the highest original issue discounts are typically zero-coupon bond. As the name indicates, these debt instruments do not pay a coupon interest payment. Without this to entice buyers, they must offer deeper discounts as compared to bonds that pay interest and sell at their face values. The only way for investors to earn income from a zero-coupon bond is from the difference between the bond's purchase price, and its face value at maturity.

Zero-coupon bonds save the costs of interest payments for the issuer at the expense of the lower initial selling price. Once the bonds mature, they are redeemed for full face value.

Since they don't pay a coupon, zero-coupon bonds are not affected by interest rate fluctuations. Typically, if interest rates rise significantly, existing fixed-rate bonds become less attractive, and their prices fall as investors sell them for higher-rate bonds elsewhere. Conversely, if interest rates fall significantly, existing fixed-rate bonds become more attractive, and their prices rise as investors rush to buy them.

Without the impact of changes to the market interest rate, some consider these investments low-risk. However, zero-coupon bonds are generally not as liquid so there will be limited buyers and sellers on the secondary bond market.

Original Issue Discounts and Default Risk

Just like you need to examine a sweater selling for a discount for flaws, the same care must be taken with OID bonds. One that is offering a large OID might be selling at a discount because the bond issuer is in financial distress. Also, a bond selling at a discount might mean there's a lack of investors willing to buy it for some reason. There may be an expectation the company might default on the bond. A default is when an issuer can no longer make interest payments or repay the principal amount that bondholders had initially invested.

If corporate bonds default, investors have little recourse. Although bondholders are paid before common stockholders in the event of a company's bankruptcy, there is no guarantee that the investor will receive the return of the full amount of their investment, if anything at all.

Although investors are compensated somewhat for their risk by being able to buy the bond at a discounted price, they should weigh the risks versus the rewards carefully.

Pros

  • Investors pay less than the par value for an OID bond.

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

  • OID bonds are less affected by fluctuations in interest rates.

Cons

  • Discounted bonds can indicate an issuer is facing financial difficulty.

  • The OID may not offset rates offered by traditional fixed-rate bonds.

  • Investors could face an annual tax liability before the bond matures.

Original Issue Discounts and Tax Liability

It's important for investors to contact a tax professional or review the IRS tax code before investing in bonds that are considered original issue discounts. It is probable that the difference between the discounted purchase price and the face value is taxable. However, investors may need to declare a portion of the income earned each year they hold the bond even though they have not received the face value amount at maturity.

Real-World Example of an Original Issue Discount

As an example, consider a 2019 offering by KushCo Holdings Inc. (KSHB). According to The Associated Press News, the business is floating a senior unsecured note for over US$21.3 million. This 18-month note is being issued as an original issue discount.

The issue is being placed with a private placement firm and will not be registered under the U.S. Securities Act and as such, cannot be sold in the U.S. The company's stock currently trades over-the-counter, and Morningstar shows the company posted negative free cash flow of $32.8 million for 2018.