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 issued. Bonds can be issued at a price lower than their face value or at 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 Discount
Original Issue Discounts Explained
The OID is the difference between a bond's purchase price by an investor and the bond’s face value also known as par value. An investor might purchase a bond for its face value amount. The issuer of the bond in return usually pays the bondholder an interest rate, called a coupon rate while the investor holds the bond. Each year, the bondholder is paid interest payments based on the rate of the bond, and when the bond matures, the investor is paid back the face value amount of the bond.
However, some bonds sell for a lower price than the face value of the bond. For example, a bond that has a $100 face value would pay the investor $100 at its maturity. If the investor buys a $100 bond for $95 and receives $100 at maturity, the OID is $5 or the return on the investment. 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.
As opposed to traditional bonds that pay interest payments periodically, the gain from the OID is only realized at maturity or when the investor is paid the face value of the bond. In other words, the OID is paid as a total sum at maturity, along with the original amount invested or principal.
Original issue discounts are used by bond issuers to entice buyers to purchase their bonds so that the issuers can raise funds for its business.
- The original issue discount (OID) is the amount of discount or the difference between the original face value amount and the price paid for the 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.
Original Issue Discounts and Interest Rates
A company can have a bond that sells at a discount to its face value while it also pays interest. However, the amount of OID tends to inversely correlate with the interest rate on the bond. In other words, the bigger the discount, the lower the 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 doesn't have to pay a high-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's likely to sell at a discount, and its OID would be smaller. If a bond's rate is attractive to investors, there'll likely be buying interest and demand for the bond, so it's not likely it will sell for much of a discount.
However, the return from the OID can be lower than the interest rate being offered on traditional bonds. Just because a bond is selling for a discount, doesn't necessarily mean that investors are getting a better deal that had they purchased a traditional fixed-rate bond. The OID amount plus any interest paid on the discounted bond needs to be higher than the total interest earned on the alternative fixed-rate bond.
Original Issue Discount and Zero-Coupon Bonds
The bonds with the highest original issue discounts are typically zero-coupon bonds. A zero-coupon bond means the bond doesn't pay any interest. As a result, a zero-coupon bond needs to sell at a deeper discount to attract investors as compared to bonds that pay interest and sell at their face values. Since the only way for investors to earn income from a zero-coupon bond is from the difference between the bond's purchase price and it's face value at maturity, the difference between those two values or OID needs to be significant enough to attract investors.
Zero-coupon bonds provide value to their issuers as it eliminates the need for interest payments during the life of the bonds. 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 can be cashed in for full face value. Investors only realize a profit or the OID, when the bond reaches maturity, and they're paid the face value of the bond.
Zero-coupon bonds are attractive to investors because they tend to be unaffected 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. Since zero-coupon bonds don't pay interest, they're considered low-risk investments since they're not affected by interest rate moves. However, zero-coupon bonds are generally not seen as liquid meaning there can be limited buyers and sellers trading them.
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's likely the difference between the discounted purchase price and the face value is taxable. However, investors may need to declare a portion of the income each year they hold the bond even though they're not paid the face value amount until maturity. In other words, an OID may result in an annual tax payment despite not earning a gain until the bond matures.
Original Issue Discounts and Default Risk
A bond that's 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, or there's 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 a corporate bond defaults, for example, investors have little recourse. Although bondholders are paid before common stockholders in the event of a company's bankruptcy, investors might not be paid 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.
OID bonds have the potential for gains since investors can buy the bonds for a lower price than their face value
Zero-coupon bonds have the largest OIDs and offer investors enhanced returns
OID bonds are less affected by fluctuations in interest rates
OID bonds sold at a discount could indicate an issuer is facing financial difficulty and default is possible
The original issue discount amount might not be enough to offset the rates offered by traditional fixed-rate bonds
Investors could face an annual tax liability despite not being paid the face value of the bond until maturity
Real World Example of an Original Issue Discount
Let's say as an example, Exxon Mobil Corporation (XOM) has issued a zero-coupon bond with a $1,000 face value and has a maturity of 10 years. The bond is selling for a price of $950 in the market.
The investor who holds the bond until maturity will be paid $1,000 in principal and realize a $50 profit or the OID ($1,000 - $950). The investor would earn 5% in interest or ($50/$1,000).
If interest rates had fallen to 2% while the bond was owned by the bondholder, the investor's return of 5% would have beat the market. However, if rates had risen to 7% while holding the bond, the investor would have underperformed the market.