how an original issue discount oid works
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 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 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 formula and calculation of oidthe oid is the difference between the stated redemption price and the issuance price the discounted offering price of the debt oid redemption price issuance pricelet s say that a company wants to raise 100 000 redemption price in the form of debt but is willing to accept 90 000 in capital issuance price therefore the oid equals 10 000 oid 100 000 90 000 10 000oids and interest ratesa 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 oids and zero coupon bondsthe bonds with the highest original issue discounts are typically zero coupon bonds 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 oids and default riskjust 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 advantages and disadvantages of oidinvestors 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 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 oids and tax liabilityit 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 since the oid on a bond is a type of interest and will serve as a source of income when it reaches maturity the irs may expect you to pay taxes on that money the difference between the discounted purchase price and the face value also keep in mind that even though some oid bonds don t pay any interest until they reach maturity investors still may need to declare a portion of the income earned each year they hold the bond each year an oid bond s holder receives a form 1099 oid from the issuer of the bond if the interest accrued is 10 or more the form will show how much the bond has accrued that year that amount must be reported as income on the tax return since taxes are paid each year oid bond holders don t receive a tax bill for the whole amount when the bond reaches maturity real world example of an oidas an example in 2019 kushco holdings inc kshb sold or floated a senior unsecured note for over 21 3 million this 18 month note was issued as an original issue discount as stated by the company in its press release the note is being issued at an original issue discount and will not bear additional interest 1the issue was placed with a private placement firm and was not 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 