What Is an Original Issue Discount (OID)?
The Original Issue Discount (OID) is the difference between the original face value amount and the discounted price paid for a bond. These bonds offer the potential for gains, as investors can purchase them at a lower price than their face value. However, it's important to note that if OID bonds are sold at a discount, it could indicate that the issuer is experiencing financial difficulties and that default is possible.
When a bond or debt instrument is issued, it is initially offered at a discount from its face value, known as an initial issue discount. These bonds may be introduced to the market at a value beneath their face value, denoted as a discount. The OID quantifies this discount, delineating the variance between the original face value and the actual purchase price of the bond.
Issuers strategically employ original issue discounts to stimulate interest among potential buyers, facilitating the accumulation of funds for their enterprises. A common tactic involves the utilization of substantial OIDs in zero-coupon bonds to attract purchasers to their offerings.
How Does an Original Issue Discount (OID) Work?
Upon acquisition, bond issuers typically remit interest payments, known as coupons, to bondholders throughout the bond-holding period. These periodic interest payments are determined by the bond's interest rate. At the bond's maturity, the investor is reimbursed the face value initially paid for the bond.
Nevertheless, certain bonds are sold below their face or par value. The OID represents the disparity between the purchase price and the face value of the bond. This OID can be regarded as interest, as the investor ultimately receives the face value at maturity despite initially paying less. To illustrate, consider a bond with a $100 face value. If an investor purchases the bond for $95 and receives $100 at maturity, the OID amounts to $5, constituting the investment's return.
In contrast to conventional bonds, the benefits of the OID materialize solely at maturity when the investor receives the principal's face value along with the initially invested amount.
Computation of Original Issue Discount
The OID is determined by subtracting the issuance price (the discounted offering price) from the stated redemption price using the formula:
OID = Redemption Price – Issuance Price
- Redemption Price: The bonds' par value, indicating the sum to be repaid at the maturity date.
- Issuance Price: The sale price of the bonds on the date of issuance.
Example of OID Computation
Consider a scenario where a corporation seeks to generate $100,000 (redemption price) through debt issuance yet opts for $90,000 in capital (issuance price). Consequently, the calculated OID amounts to $10,000:
Interplay Between OIDs and Interest Rates
Bonds in a company's portfolio may be sold below their face value, accompanied by periodic interest payments. Notably, the magnitude of the Original Issue Discount exhibits an inverse relationship with the bond's interest rate. A higher discount typically corresponds to a lower coupon rate on the bond.
This negative correlation arises from companies issuing bonds at a discount to alleviate the burden of sustaining a consistently high-interest rate for investors. While bond interest is income for investors, it translates into an expense for companies.
Conversely, bonds with higher interest rates are less likely to experience discounts, resulting in smaller OIDs, if any. Bonds with attractive rates garner significant demand, minimizing the likelihood of substantial discounts.
Investors should discern that acquiring a discounted bond doesn't necessarily translate to a favorable deal. The cumulative return from the OID, in addition to regular coupon payments, must surpass alternative fixed-rate products to deem it advantageous. Careful comparison is essential.
Zero-Coupon Bonds and Original Issue Discounts
Zero-coupon bonds, characterized by the absence of coupon interest payments, typically exhibit the highest original issue discounts. Unlike interest-paying bonds at face value, zero-coupon bonds lack coupon enticements and necessitate deeper discounts to attract buyers. Investors derive income solely from the variance between the bond's purchase price and its face value at maturity. This savings in interest payments for the issuer is offset by the lower initial selling price of zero-coupon bonds. Upon maturity, these bonds are redeemed at their full face value.
Zero-coupon bonds remain unaffected by fluctuations in interest rates, distinguishing them from fixed-rate bonds. The conventional impact of interest rate shifts on bond prices is circumvented, making zero-coupon bonds appear low-risk. Despite this, their limited liquidity on the secondary bond market restricts buyer and seller participation.
OID Bonds and Risk of Default
Similar to inspecting a discounted sweater for flaws, thorough scrutiny is essential for OID bonds. A substantial OID may indicate financial distress on the part of the bond issuer, leading to the discounted sale. Furthermore, a bond trading at a discount may show insufficient investor interest, which could be due to concerns about the issuer's ability to fulfill its obligations. This situation could result in a default.
Default occurs when an issuer cannot fulfill interest payments or repay the principal investment amount to bondholders. In the unfortunate event of corporate bond default, investors face limited recourse. While bondholders are prioritized over common stockholders in a company's bankruptcy, there is no assurance of receiving the full return on their investment, if any. While investors enjoy a discounted purchase price, signifying compensation for risk, careful evaluation of the risks versus rewards is imperative.
Pros and Cons of Original Issue Discounts
- Investors acquire OID bonds below the par value.
- Zero-coupon bonds leverage substantial OIDs to attract investors.
- OID bonds demonstrate resilience to interest rate fluctuations.
- Discounted bonds may signal financial distress for the issuer.
- The OID might not counterbalance rates provided by traditional fixed-rate bonds.
- Investors may encounter annual tax liabilities before bond maturity.
Tax Implications of OIDs
Before delving into bonds classified as original issue discounts, investors are advised to consult a tax professional or familiarize themselves with the IRS tax code. Given that OID on a bond is considered a form of interest, constituting income upon maturity, the IRS may necessitate tax payments on the accrued difference between the discounted purchase price and the face value.
Furthermore, it's crucial to note that even when certain OID bonds defer interest payments until maturity, investors may still be obligated to declare a portion of their annual income throughout the bond's holding period.
Annually, the bondholder of an OID bond receives Form 1099-OID from the bond issuer if the accrued interest surpasses $10. This form delineates the year's accumulated amount, which must be reported as income in the tax return. The incremental tax payments each year eliminate the need for OID bondholders to settle a comprehensive tax bill upon the bond's maturity.
Original Issue Discount Example
In 2019, KushCo Holdings Inc. (KSHB) executed the issuance of a senior unsecured note amounting to more than $21.3 million. The company explicitly characterized this 18-month note as an original issue discount in its official statement, clarifying that it would not accrue additional interest.
This private placement was facilitated through an unregistered transaction with a private placement firm, falling outside the purview of the U.S. Securities Act. Consequently, the note is ineligible for sale within the United States, and the company's stock is presently traded over-the-counter.
Companies occasionally extend original issue discounts during the sale of face value bonds or comparable debt instruments at a reduced rate. Generally, bonds are traded at maturity for an amount below their designated worth. This variance between the selling and stated values constitutes the OID, serving as supplementary interest income for the purchaser.
Buyers must report the OID amount as part of their taxable income, accumulating throughout the bond's remaining tenure, irrespective of any issuer payments during this period. Furthermore, buyers may be subject to taxes on the tangible interest income received.