Original Issue Discount (OID)

Definition

Original Issue Discount (OID) is a type of discount from the par value, or face value, of a bond at the time it is issued. Essentially, it represents the difference between a bond’s face value and its selling price when initially issued. The most extreme version of an OID is exhibited in zero-coupon bonds, which are sold substantially below their par values and do not pay interest until they mature.

The tax treatment of OID bonds is detailed and must be carefully managed, as the OID needs to be amortized over the bond’s life. This process incrementally increases the basis of the bond over time.

Examples

Zero-Coupon Bond: A bond with a face value of $1,000 issued at $600. The $400 discount is the OID, fully realized at maturity.
Corporate Bonds: A company issues a $10,000 bond at $9,500. The initial $500 difference is treated as OID.
Municipal Bonds: A city issues a $5,000 bond at $4,800. The $200 difference is the OID.

Frequently Asked Questions (FAQs)

What is Original Issue Discount (OID)?

OID refers to the discount from the bond’s par value when it is initially issued. This discount represents the interest to be received at maturity.

How is OID taxed?

OID is treated as interest for tax purposes and must be included in the investor’s taxable income over the bond’s life through amortization.

What is an example of an extreme Original Issue Discount (OID)?

Zero-coupon bonds are the most extreme example, often sold at significant discounts and paying no interest until maturity.

Why is the basis of a bond important in the context of OID?

The basis of a bond reflects its adjusted cost, which affects capital gains or losses upon sale or maturity. OID amortization increases the bond’s basis over time.

Can all bonds have an OID?

Not all bonds have an OID. It primarily occurs in bonds issued at a discount to their face value.

Par Value: The face value of a bond, which is the amount the issuer agrees to pay back at maturity.
Zero-Coupon Bond: A bond that does not pay periodic interest and is sold significantly below face value, with interest realized upon maturity.
Amortization: The process of gradually writing off the initial cost of an asset over time.
Basis: The bond’s adjusted purchase price used for calculating capital gains or losses.

Online Resources

Suggested Books for Further Studies

“Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman, Angel Serrat.
“The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More” by Annette Thau.
“Fixed Income Analysis” by Barbara S. Petitt, Jerald E. Pinto.

Fundamentals of Original Issue Discount (OID): Finance Basics Quiz

### What does Original Issue Discount (OID) represent? - [x] The discount from par value at the time of issuance. - [ ] The premium from par value at the time of issuance. - [ ] The interest paid periodically on the bond. - [ ] The principal amount of the bond. > **Explanation:** OID represents the initial discount from a bond's par value when it is issued, not the premium. ### Which bond type typically features the most extreme form of OID? - [x] Zero-coupon bond. - [ ] Corporate bond. - [ ] Municipal bond. - [ ] Treasury bond. > **Explanation:** Zero-coupon bonds are sold significantly below face value and do not pay interest until maturity, representing the most extreme form of OID. ### How is OID treated for tax purposes? - [ ] It is ignored. - [x] It must be amortized over the life of the bond. - [ ] It is deducted at maturity. - [ ] It affects only state income tax. > **Explanation:** OID must be amortized over the bond's life for tax purposes, incrementally increasing the bond's basis. ### What happens to the basis of a bond with OID over time? - [ ] It decreases. - [ ] It remains the same. - [x] It increases. - [ ] It depends on interest rates. > **Explanation:** The basis of a bond with OID increases over time as the discount is amortized. ### Which IRS publication provides detailed guidance on OID? - [ ] Publication 925 - [x] Publication 1212 - [ ] Publication 502 - [ ] Publication 225 > **Explanation:** IRS Publication 1212 provides detailed guidance on the tax treatment of OID instruments. ### What is the par value of a bond? - [ ] The discount at issuance. - [x] The face value paid at maturity. - [ ] The market value. - [ ] The interest rate. > **Explanation:** The par value is the bond's face value, the amount paid back to the investor at maturity. ### What does "amortization" in bond terms refer to? - [ ] Increasing interest payments. - [ ] Paying off the principal early. - [x] Gradually writing off the initial cost over time. - [ ] Issuing new bonds. > **Explanation:** Amortization in bond terms refers to gradually writing off the initial cost of the bond over its term. ### What distinguishes zero-coupon bonds from other bonds? - [x] They pay no interest until maturity. - [ ] They offer variable interest rates. - [ ] They mature within a year. - [ ] They are issued at a premium. > **Explanation:** Zero-coupon bonds do not pay periodic interest and are sold at a deep discount, with interest realized at maturity. ### How is OID reflected in an investor's income? - [ ] As an equity gain. - [ ] As a capital loss. - [x] As interest income. - [ ] It is not reflected. > **Explanation:** OID is treated as interest income and must be included in the investor's taxable income annually. ### In the context of OID, what increases the bondholder's basis? - [ ] Paying interest. - [ ] Selling the bond. - [x] Amortizing the discount. - [ ] Withholding taxes. > **Explanation:** The bondholder's basis increases as the OID is amortized over the life of the bond.

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