Discount Bond

Why Bonds Trade at a Discount

A bond trades below par when its coupon rate is lower than the current market yield for bonds of comparable credit quality and maturity. Investors will not pay full par value for a bond paying three percent when current market conditions offer four percent on equivalent new bonds. The price of the existing bond must fall until its total return — the fixed coupon payments plus the gain from purchasing below par and receiving par at maturity — equals the prevailing four percent market yield. That reduced price is the discount.

Three distinct circumstances produce discount bonds. First, market interest rates rise after a bond is issued, making its fixed coupon less competitive than new issues. Second, the issuer's credit quality deteriorates after issuance, causing investors to demand a higher yield to compensate for increased default risk, which drives the price down. Third, a bond is deliberately issued below par in the primary market — original issue discount — either because the issuer wishes to issue at a zero or low coupon for cash flow management reasons or because the market demands a yield above the coupon the issuer is willing to pay. Each circumstance produces a discount bond, but the tax treatment differs significantly depending on which applies.

The Yield Relationships on a Discount Bond

The defining yield relationships of a discount bond follow directly from the arithmetic of a fixed coupon payment applied to a below-par purchase price.

When a bond trades at a discount, the current yield — annual coupon divided by the market price — exceeds the coupon rate. The coupon rate is anchored to par value in the denominator. The current yield uses the lower market price in the denominator, producing a higher percentage. A four percent coupon bond paying forty dollars annually on a one-thousand-dollar par value, trading at nine hundred dollars, has a current yield of forty divided by nine hundred, equalling four point four four percent. The current yield exceeds the coupon rate because the same fixed payment is measured against a smaller investment.

The yield to maturity exceeds both the coupon rate and the current yield for a discount bond. Yield to maturity captures the full return including not only the coupon income but also the capital gain — the difference between the nine-hundred-dollar purchase price and the one-thousand-dollar par received at maturity. That gain, annualised over the remaining life of the bond, adds to the yield to maturity and pushes it above the current yield. The yield to maturity is the most complete measure because it accounts for all cash flows.

The correct ascending order of yield measures for a discount bond, from lowest to highest, is: coupon rate, then current yield, then yield to maturity. Candidates who internalise the logic — fixed coupon against a falling price produces rising yields, and the total return measure captures the most — will reproduce this sequence correctly under any examination phrasing.

Original Issue Discount Bonds

An original issue discount bond is a bond deliberately issued at a price below par value rather than a bond that has fallen to a discount in the secondary market after initial issuance. Zero coupon bonds are the most extreme form of original issue discount — they are issued at a deep discount to par and pay no periodic interest, with the entire return delivered as the difference between the purchase price and the par value received at maturity. A zero coupon Treasury bond with fifteen years to maturity and a yield to maturity of five percent would be issued at approximately four hundred and eighty dollars per one-thousand-dollar face value.

Bonds may also be issued with a positive coupon rate but at a price below par — for example, a bond carrying a four percent coupon might be issued at ninety-eight dollars per one-hundred-dollar face value when the market yield at issuance is four point two percent. The two-dollar discount per one hundred face value is the original issue discount.

The Internal Revenue Service requires that original issue discount on taxable bonds be accreted into the investor's income annually under Internal Revenue Code Section 1272, regardless of whether any cash is received. The annual accretion is calculated using the constant yield method — the effective interest rate method — which applies the bond's yield to maturity to the adjusted cost basis at the beginning of each accrual period to determine the income to be recognised. The accreted amount is treated as ordinary interest income and is reported on Form 1099-OID issued by the paying agent or broker. As each year's OID accretion is recognised as income and added to the cost basis, the investor's basis gradually increases from the original purchase price toward par over the life of the bond.

The de minimis rule provides a threshold below which original issue discount may be treated as capital gain rather than ordinary income. Under IRC Section 1273, if the total OID is less than one-quarter of one percent of the stated redemption price at maturity multiplied by the number of complete years from original issuance to maturity, the OID is considered de minimis. A bond with a one-thousand-dollar par value and ten years to maturity has a de minimis threshold of one-quarter of one percent multiplied by one thousand multiplied by ten, equalling twenty-five dollars. If the total OID is below twenty-five dollars, the investor may treat any gain attributable to the discount as capital gain rather than ordinary income at maturity.

Market Discount Bonds — The Secondary Market Distinction

A market discount bond is a bond purchased in the secondary market at a price below its adjusted issue price — the par value for bonds originally issued at par, or the original issue price plus any previously accreted OID for bonds originally issued at a discount. The market discount arises not from the original issuance terms but from secondary market price movements driven by rising interest rates or deteriorating credit quality after issuance.

The tax treatment of market discount differs from original issue discount in a significant way. Under IRC Section 1276, gain on the disposition of a market discount bond is treated as ordinary income to the extent of the accrued market discount — the portion of the total discount that has economically accreted from the purchase date to the date of disposition. The remainder of any gain, if the bond is sold above the accreted basis but below par, is a capital gain. If the bond is held to maturity and redeemed at par, the entire discount is recognised as ordinary income in the year of maturity.

Investors may elect under IRC Section 1278 to include the accrued market discount in income annually — treating it as ordinary interest income each year just as OID is treated — rather than deferring recognition until sale or maturity. This annual inclusion election increases current tax liability but reduces the ordinary income recognised at maturity or sale, giving the investor greater control over the timing of tax recognition. The election applies to all market discount bonds acquired in the year of election and thereafter, and once made is irrevocable for that bond.

The accrued market discount for purposes of the ordinary income characterisation is computed under the ratable accrual method — the total discount multiplied by the ratio of days held to total days remaining at acquisition — unless the investor elects the constant yield method, which produces the same result as OID accretion and allocates more discount to earlier periods.

Zero Coupon Bonds — The Phantom Income Problem

Zero coupon bonds represent the purest form of discount bond and the most acute illustration of the original issue discount taxation issue. An investor who purchases a zero coupon corporate bond receives no cash payments until maturity but must recognise OID income annually as the discount accretes. The investor owes tax each year on income they have not yet received in cash — commonly called phantom income. This characteristic makes zero coupon bonds generally unsuitable for taxable accounts because the investor must fund the annual tax liability from outside the bond position.

Zero coupon bonds are highly appropriate for tax-deferred accounts such as traditional individual retirement accounts and 401(k) plans, where the annual OID accretion is not immediately taxable and the full compounding effect of the yield operates without annual tax drag. They are also used by investors who need to match a specific future liability — such as a known tuition payment or a pension obligation — with a known future payment, because the zero coupon bond's single maturity payment eliminates reinvestment risk entirely.

Zero coupon Treasury securities — created through the STRIPS program administered by the Federal Reserve — allow investors to purchase the stripped principal and coupon components of Treasury bonds as separate zero coupon instruments. Treasury STRIPS retain the full faith and credit backing of Treasury securities while delivering the zero coupon structure. OID on Treasury STRIPS is subject to federal income tax but exempt from state and local income taxes, consistent with the tax treatment of all Treasury interest.

The Discount Bond and Price Sensitivity

Discount bonds exhibit greater price sensitivity to changes in interest rates than premium bonds of equivalent maturity, for a reason rooted in the mathematics of present value. A discount bond has a higher yield to maturity than a premium bond of the same maturity, which means the discount bond's cash flows are discounted at a higher rate. Duration — the weighted average time to receipt of cash flows, where each cash flow is weighted by its present value — is higher for the lower coupon discount bond than for the higher coupon premium bond at the same maturity, because the smaller coupon payments receive less weight in the present value calculation, increasing the relative weight of the par payment at maturity. This higher duration produces greater price sensitivity per unit of yield change — discount bonds gain more when rates fall and lose more when rates rise than equivalent premium bonds.

STRIPS and Municipal Discount Bonds

The examination curriculum occasionally tests the specific tax treatment of stripped Treasury securities and the treatment of original issue discount on tax-exempt municipal bonds.

Treasury STRIPS are zero coupon instruments created when the coupon payments and principal payment of a Treasury note or bond are separated and sold individually. The OID on Treasury STRIPS must be accreted annually as ordinary income for federal tax purposes even though no cash is received, but is exempt from state and local taxes. Because of the phantom income problem, Treasury STRIPS are most commonly held in tax-deferred retirement accounts.

Municipal bonds with original issue discount require the OID to be accreted annually, but because municipal bond interest is generally exempt from federal income tax, the accreted OID is also tax-exempt. The accreted basis increases each year, and if the bond is sold above its accreted basis, any gain above the accreted value may be taxable as capital gain. Municipal bonds purchased in the secondary market at a market discount — after original issue — are subject to the market discount rules of IRC Section 1276 and produce ordinary income to the extent of accrued market discount upon sale or maturity, even though the coupon interest itself is tax-exempt. This market discount taxation on otherwise tax-exempt bonds is a specific and frequently tested examination point.

Examination Relevance and Key Takeaways

Discount bonds are tested on the SIE, Series 7, and Series 65 examinations in the context of bond pricing, yield relationships, original issue discount taxation, market discount taxation, and zero coupon bonds.

The core points to retain are these: a discount bond trades below par because its coupon rate is below current market yields for comparable bonds, because the issuer's credit quality has deteriorated, or because it was originally issued below par; the yield order for a discount bond from lowest to highest is coupon rate, current yield, yield to maturity; original issue discount under IRC Section 1272 must be accreted annually as ordinary interest income reported on Form 1099-OID using the constant yield method, with the de minimis rule under IRC Section 1273 treating small discounts below one-quarter of one percent of par times years to maturity as capital gain; market discount under IRC Section 1276 is recognised as ordinary income to the extent of accrued market discount upon sale or maturity, with investors able to elect annual accrual under IRC Section 1278; zero coupon bonds are the most extreme original issue discount instruments, making no cash payments until maturity but requiring annual OID income recognition creating phantom income that makes them generally unsuitable for taxable accounts but highly appropriate for tax-deferred retirement accounts; Treasury STRIPS are zero coupon instruments created through the Federal Reserve's STRIPS program, subject to federal OID taxation but exempt from state and local taxes; municipal bonds originally issued at a discount have tax-exempt OID accretion but municipal bonds purchased in the secondary market at a market discount produce ordinary income characterisation on the discount portion upon sale or maturity even though coupon interest is tax-exempt; and discount bonds have higher duration and therefore greater price sensitivity to interest rate changes than premium bonds of the same maturity because lower coupons increase the relative weight of the distant par payment.