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 the 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, enabling issuers to raise funds for their business needs. Many zero-coupon bonds use large OIDs to entice buyers to their products.
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 that the issuer is facing financial difficulty and default is possible.
Understanding How Original Issue Discount (OID) Works
Once purchased, the bond’s issuer usually pays the bondholder an interest rate—known as a coupon—while the investor holds the bond. Periodically, the bondholder receives interest payments based on the bond’s rate. When the bond reaches maturity, the investor gets the return of the face value paid for the bond.
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, let’s say that a bond has a $100 face value, meaning the investor would receive $100 returned at the maturity date. If the investor buys the bond for $95 and receives $100 at maturity, the OID is $5, which is the return on the investment.
Unlike traditional bonds, the gain from the OID is only realized at maturity when the investor receives the return of the face value principal. The OID is paid as a total sum at maturity, along with the original amount invested.
Formula and Calculation of OID
The OID is the difference between the stated redemption price and the issuance price (the discounted offering price of the debt).
OID = Redemption Price - Issuance Price
- Redemption Price: The par value of the bonds (the amount obligated to be returned on the date of maturity).
- Issuance Price: The offering price that the bonds were sold for on the date of sale.
Example of Calculating OID
Let’s say a company wants to raise $100,000 (redemption price) via debt but accepts $90,000 in capital (issuance price). Therefore, the OID equals $10,000:
OID = $100,000 - $90,000 = $10,000
OID and Interest Rates
A company can have a bond that sells at a discount to its face value while also paying periodic interest. However, the amount of OID tends to correlate inversely with the interest rate on the bond. In other words, the bigger the discount, the lower the coupon rate offered on the bond.
The negative correlation exists because companies might issue a bond at a discount to its face value to mitigate the need for paying 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 likely it will sell at a discount. If a bond’s rate is attractive to investors, there will likely be many buyers for it, reducing the chance that it will sell for much of a discount.
Investors should understand that a bond selling at a discount does not necessarily mean it is a bargain. The return received for the OID may end up less than the interest rate offered on a traditional fixed-rate bond. To make the investment worthwhile, the original issue discount plus total regular coupon payments must be higher than compared fixed-rate products.
OID and Zero-Coupon Bonds
The bonds with the highest original issue discounts are typically zero-coupon bonds. As the name indicates, these debt instruments do not pay coupon interest payments. Without this incentive for buyers, they often offer deeper discounts compared to interest-paying bonds that 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 help issuers save on the costs tied to interest payments, at the expense of a lower initial selling price. Once these bonds mature, they are redeemed for their full face value.
Zero-coupon bonds are generally not as impacted by interest rate fluctuations, which many consider these investments low-risk. However, zero-coupon bonds are not as liquid, meaning there will be limited buyers and sellers on the secondary bond market.
OID and Default Risk
Just as you would carefully examine a sweater selling for a discount for defects, the same care must be taken with OID bonds. An offering a large OID might be selling at a discount because the bond issuer is in financial distress. A bond selling at a discount may also signify a lack of investor willingness to buy, possibly due to an expectation that the company might default on the bond. A default occurs when an issuer can no longer make interest payments or repay the principal amount that investors initially invested.
If corporate bonds default, investors have scant recourse. Although bondholders are paid before common stockholders if a company declares bankruptcy, there’s no guarantee investors will recoup the full amount of their investment.
While investors are somewhat compensated for their risk by purchasing the bond at a discounted price, they should weight the risk versus the rewards vigilantly.
Advantages and Disadvantages of OID
Original Issue Discount Pros and Cons
Pros
- Investors pay less than the par value for an OID bond.
- Zero-coupon bonds utilize large OIDs to attract investors.
- OID bonds are less affected by fluctuations in interest rates.
Cons
- Discounted bonds may indicate the issuer faces financial difficulties.
- The OID may not offset the rates offered by traditional fixed-rate bonds.
- Investors could face an annual tax liability before the bond matures.
OID and Tax Liability
Before investing in bonds considered original issue discounts, it’s crucial for investors to contact a tax professional or thoroughly review the IRS tax code. Since the OID on a bond is a type of interest and will be considered a source of income once it reaches maturity, the IRS may expect taxes on that income (the difference between the discounted purchase price and the face value).
Additionally, even though some OID bonds don’t pay any interest until they mature, investors may need to declare a portion of the income earned each year they hold the bond.
Each year, an OID bondholder receives a Form 1099-OID from the bond issuer if the interest accrued is $10 or more. The form indicates how much the bond has accrued that year, which must be reported as income on the tax return. Since taxes are paid annually, OID bondholders don’t face a tax bill for the full amount when the bond matures.
Real-World Example of an OID
In 2019, KushCo Holdings Inc. (KSHB) floated a senior unsecured note for over $21.3 million. This 18-month note was issued as an original issue discount, as stated in the company’s press release: “The Note is being issued at an original issue discount and will not bear additional interest.”
The note was placed with a private placement firm and wasn’t registered under the U.S. Securities Act, barring its sale in the U.S. The company’s stock currently trades over-the-counter.
How Is OID Calculated?
The OID equals the difference between the stated redemption price of a bond and its initial issuance price. It can be calculated by subtracting the issuance price from the redemption price.
What Is Interest OID?
OID is a form of interest on a debt instrument such as a bond or note issued at less than its face value. A debt instrument generally has a discount when it’s issued for a price lower than its stated redemption price at maturity. For tax purposes, this interest is considered income.
How Do I Report OID on My Tax Return?
Taxpayers should utilize Form 1099-OID, Original Issue Discount, to report any taxable OID interest. This type of interest is usually taxed as ordinary income. However, if a short-term discount obligation is redeemed at maturation, it should be filed as 1099-INT. Brokers and middlemen typically provide clients with the appropriate form for tax purposes.
The Bottom Line
An original issue discount (OID) might be presented by companies when they sell face value bonds or other debt instruments at a discount. Bonds are often sold at maturity for a value lower than their stated value, with the difference between the two prices representing the OID, considered additional interest income for the buyer.
The OID amount must be reported as part of taxable income as it accrues over the bond’s remaining life, regardless of any payments received from the issuer during that time. Beyond that, the buyer remains responsible for taxes on the actual interest income received.
Related Terms: face value, coupon rate, maturity date, market discount, fixed-income securities.
References
- Kushco Holdings. “KUSHCO HOLDINGS, INC. ANNOUNCES THE PRIVATE PLACEMENT OF US$21,300,000 SENIOR UNSECURED NOTE”.
- Internal Revenue Service. “Publication 1212: Guide to Original Issue Discount (OID) Instruments”.
