Governments and large corporate financial institutes issue bonds to raise funds. These bonds offer a return on investment through periodic payments called coupons or through capital gains on realization.
As these bonds are usually offered by Government and financially strong institutes, these instruments are considered secured investments. Some bonds are issued with a fixed interest rate, some with a variable interest rate, and other without coupon payments.
Investors are attracted to investments in bonds for their regular payments and market value appreciation. Many investors purchase bonds to resale with favorable trade opportunities. In some cases, the issuer institute may face hardships in attaining suitable buyers for bonds issued.
They offer a discount to the bond face value originally issued. That lures in the investors to invest in the bonds with a discount and sell them later with higher prices.
Bonds are issued with a face or par value usually denominated at $ 100 or $ 1,000. If the issuer offers the bond at less than its original face value it’s deemed to be sold with an original issue discount or OID. The amount or discount is then a straightforward difference between the par value and the value at which it sells.
Why Bond issuers offer original issue discounts?
- It attracts investors to buy the bonds at lower than the face value of the bonds
- The coupon rate offered with bonds usually is related to the value of the bond, discounted bond value reduces the coupon payments
Usually, investors interested in buying securities held-for-sale are attracted to the OID bonds. They hope to sell these bonds quickly in the financial markets to realize the capital gains on investments.
The bond issuers offer a higher discount on zero-coupon bonds. Zero-coupon bonds do not pay regular interest payments to the investors instead the investors look to realize profits with capital gains. If the bonds do not sell the investor’s only return with a zero-coupon bond with OID is the difference in the face value at maturity and discount price offered.
It makes an easier option for issuers to offer zero-coupon bonds with higher discounts. Interest rate fluctuations affect the fixed-rate bonds but not so the zero-coupon bonds.
As zero-coupon bonds do not pay any interest payments, they are usually considered safer investments. The only concern for investors is that a bond with zero-coupon and issued at discount would not attract any buyers.
Original Issue Discount and Bond interest:
It is highly unlikely that a bond issuer would offer a discount on the face value of the bond and keep the interest or coupon payments at the same rate. Remember, bonds are a form of long-term debt that the issuer would have to repay upon maturity.
The bond issuers offer discounts in financially stressed situations but are highly unlikely to keep the same interest rates. Otherwise, there is no benefit for the issuers as both discounts in original face value and higher interest payments would make it a highly expensive instrument.
From the investors’ point of view, they must consider the higher the OID the lower their bond yield. However, it depends on the investor policy whether they hold the bond to maturity or sell it to the market. Lower interest rates would mean that the investor may receive fewer short-term gains in comparison to the fixed-rate bonds or other securities.
Tax Implications of the Original Issue Discount:
The investors need to declare the coupon yield on bonds in their tax filing annually. However, capital gains or losses on OID arising due to the difference in the face value and discount can be declared at the time of capital gains/losses realization.
Original Issue Discount – important Considerations:
- Investors must consider the default risk of the OID bond issuers. Normally, OID bonds are issued when a company is in a financial crunch
- investors looking for a held-for-sale policy should consider the fact that OID bonds are less attractive in the financial market
- investors need less up-front investment with OID bonds than normally priced bonds
- OID bonds usually come with a zero-coupon interest policy
As bonds are usually considered safer debt instruments, they offer fewer yields than other forms of investments and stocks. Most investors are interested in held-for-trading investments in the bonds. Bond pricing is also affected by this demand and supply rule, similar to the stocks in the financial markets.
The main attraction for investors in bonds against stocks is that bonds are secured investments. However, investors must consider the default risk, as in case of default the bonds are also less secured.