What is an Original Issue Discount (OID)?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

An original issue discount (OID) is the difference between the face value and the sale price of a bond, which serves as interest paid to the bondholder.

🤔 Understanding an original issue discount

The face value (aka par value) of a bond is the amount the bondholder will receive from the issuer at the time of maturity. But bond issuers don’t always sell bonds for face value. You might pay less than face value, and then get more than you paid back at the time of maturity. This discrepancy is known as an original issue discount (OID). The OID acts as extra interest income that the bondholder gets at the very end, in addition to the interest payments they receive during the life of the bond. In the case of some bonds, such as zero-coupon bonds, the OID is the only interest the bondholder will earn from the investment.

Example

Let’s say the fictional Construction Company Z issues bonds to raise a bit of capital for an upcoming project. The debt securities are zero-coupon bonds with a face value of $100. The company initially sells the bonds for $85 each. Roberta buys one of the bonds. Because they’re zero-coupon, Roberta and the other bondholders won’t receive interest payments throughout the life of the bond. But when the bonds mature, Roberta will receive $100 from the construction company. Since she only paid $85 for the bond, she’s gained a profit of $15.

Takeaway

An original issue discount is like a discounted gift card for a restaurant that hasn’t opened yet…

Let’s say a new restaurant is opening in your neighborhood. To drum up business and help cover opening costs, they offer a $100 gift card and sell it for $80. When the restaurant opens the next month, you can go and get $100 worth of food; but you only paid $80 for it. Similarly, an OID bond makes you wait for the payoff, but you’re getting the face value of the bond at a discounted price.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

Tell me more…

What is an original issue discount (OID)?

An original issue discount (OID) is the difference between the face value of a bond and the price at which the issuer originally sells the bond. When the bond reaches maturity, the issuer will pay the bond’s full face value to the bondholder. The OID will serve as interest income for the bondholder.

In some cases, a company may issue a bond with an OID, while still making interest payments throughout the life of the bond. But often bonds with an OID are zero-coupon bonds, meaning they don’t result in recurring interest income for the owner.

How do OIDs work?

The purpose of an original issue discount (OID) is to serve as interest for the bondholder. Suppose an investor buys a bond with a face value of $1,000, but the investor only pays $800 to buy it. When the bond reaches maturity, the bond’s issuer has to pay the full face value, meaning it owes the bondholder $1,000. $800 of that payment is the principal amount, meaning the amount the investor originally gave the issuer. The extra $200 is the interest the issuer pays to borrow the money.

How does OID work with interest rates?

A bond is basically a loan that an investor makes to a bond issuer (usually a corporation or a government). As with other types of loans, bonds result in interest income for the lender.

Many bonds require the issuer to make regular interest payments throughout the life of the loan, either at a fixed or a floating rate (meaning the rate adjusts based on the fluctuations of an index rate). The yield of these bonds is heavily dependent on interest rates, either at the time of issue in the case of fixed-rate bonds, or throughout the life of the loan for a floating-rate bond. If interest rates go down on a floating-rate bond, a bondholders income might go down with it.

An original issue discount (OID) is also a form of interest. But instead of receiving this income in regular increments like other interest payments, the bondholder receives the whole OID yield at the time the bond reaches its maturity date. OIDs aren’t affected by market interest rates changing over the life of the bond, as the OID is determined at the time of issue.

How does OID work with zero-coupon bonds?

Many bonds require that the issuer make regular interest payments to the bondholder. A zero-coupon bond is one that doesn’t come with any interest payments throughout its life. Instead, the yield of a zero-coupon bond comes entirely from the discount at which the owner buys it. These bonds usually come with an original issue discount (OID).

How does OID work with default risk?

Unless you only buy bonds from the U.S. Treasury Department, which the federal government backs, then you always face some level of default risk. Consider a bank lending money to a consumer. There’s a risk for the bank that the consumer won’t pay back the loan. Similarly, an investor who lends money to a corporation through a bond runs the risk that the company won’t pay back its debt.

OID bonds can present an even greater default risk. Many other bonds require the issuer to make interest payments throughout the life of the bond. If the bond issuer defaults halfway to maturity, you’ve recovered some money. But an OID zero-coupon bond doesn’t make any payments until the very end. So if the issuer defaults, you risk losing all of your money.

How is OID calculated?

An original issue discount (OID) is the reduced price at which a bond is issued. The OID serves as a form of interest that the bond’s owner receives from the bond’s issuer at the time of maturity.

To calculate the OID of a bond, simply subtract the issue price from the face value. Suppose you have a bond with a face value of $1,000. The face value represents the amount of money you’ll get when the bond matures. You buy the bond for $850. The OID calculation looks like this:

$1,000 face value – $850 sale price = $150 original issue discount

How is OID taxed?

The original issue discount (OID) on a bond is a type of interest and will serve as a source of income for the bondholder when it reaches maturity. And just like any other form of income, the Internal Revenue Service (IRS) expects you to pay taxes on that money.

Even though some OID bonds don’t pay any interest until they reach maturity, the owner has to pay taxes on it over the whole life of the bond. OID is a form of taxable income that accrues each year on the bond, even if you aren’t receiving any money from it.

Each year, an OID bond’s owner will receive a Form 1099-OID from the issuer of the bond if the interest accrued is $10 or more. The form will show how much has accrued on the bond that year, and the bond’s owner will use that form to report the amount as income on your tax return. Because the income from the OID accrues over the life of the bond, and you pay taxes on it each year, you won’t be stuck with one tax bill for the whole amount when the bond reaches maturity.

What are the pros and cons of OID?

Imagine buying something from a retail store on sale, and then returning it later for the full price. That’s a bit like how an original issue discount (OID) works. When you buy an OID bond, you buy it for less than its face value. But then when the bond reaches maturity, the issuer pays you the full face value. You essentially get the benefit of buying something on sale and returning it for the full value.

Another advantage of OID bonds is that they aren’t as susceptible to interest rate fluctuations as other types of bonds. Suppose you bought a floating-rate bond, meaning one whose coupon rate follows an index rate. If interest rates suddenly plummet, so does your interest income. But that’s not the case for an OID. If an OID bond has a face value of $100, and you buy it for $80, that $20 yield doesn’t decrease if interest rates go down.

OID bonds have their downsides as well. First, while many bonds pay recurring interest throughout the life of the bond, OID is a form of interest that doesn’t pay until the very end. So in the case of zero-coupon bonds, the bond doesn’t produce any income until it reaches maturity.

The other significant downside to OID bonds is that even though you don’t receive your interest until the bond’s maturity, you’ll have to pay taxes on it each year. Imagine you have a bond with a life of 10 years. You’ll pay income taxes on a part of the interest income from the bond in year one, even though you won’t actually see that money for another decade.

What is the difference between an original issue discount and market discount?

An original issue discount (OID) is a debt instrument with a sale price that’s lower than its face value at the time of the original issue. Suppose a corporation were to issue bonds with a face value of $100. But the firm chooses to issue the bonds with a sale price of $90. That $10 difference represents the original issue discount. This term only applies when the discount exists at the time the debt securities are originally issued.

A market discount, like an OID, occurs when someone buys a bond for less than its face value. But the term market discount doesn’t generally apply to the original issuing of the bond. Instead, it applies to bond sales in a secondary market. In many cases, a market discount occurs when the debt security has lost value, often as a result of interest rate fluctuations. Suppose you were to buy a bond in a secondary market with a face value of $100. If the issuing entity originally sold the bond for $100, and you buy it for $90, there was a market discount.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

1330296

Related Articles

What is an Interest Rate?
Updated June 22, 2020

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2020 Robinhood Markets, Inc. Robinhood® is a trademark of Robinhood Markets, Inc.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. Robinhood U.K. Ltd (RHUK) provides brokerage services in the United Kingdom. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').

1200251