There are two types of original issue discount bonds (OIDs). The first type is a bond that is issued with a coupon, but at a dollar price that is considerably below par or face value of the bond. The other type is a bond that has no coupon, called a zero-coupon bond, and is issued at a discount that incorporates the market yield-to-maturity for that maturity bond.
When corporations issue bonds in the public market during high interest rate periods, the high interest payments become a cash flow burden. This is solved by issuing long-maturity, low-coupon or zero-coupon bonds at a deep discount to par, or $1,000 face value. OIDs are issued by corporations, municipalities and the U.S. Treasury, which has long been issuing zero-coupon securities in the form of Treasury bills and savings bonds.
For issuing organizations, the greatest benefit is the ability to lower or eliminate semi-annual interest payments -- particularly when interest rates are higher than 10 percent. When the bond matures, the issuer can borrow the money to pay off the interest and principal, or refinance the bond during what is likely to be a lower-interest-rate period. This reduces the cost of interest payments during the life of the bond, and results in a lower cost of money to replace the funds when the bond matures.
Benefits for Investors
For investors, the greatest benefit is the deep discount, and the fact that reinvestment interest is figured into the return. This is important because yield-to-maturity assumes the investor can reinvest the coupon payments at the same interest rate as the coupon rate. This is particularly difficult to do because market interest rates fluctuate, and if a bond is purchased during a period of exceptionally high interest rates, it is unlikely that all coupons can be reinvested at those high rates. A further benefit is the investor's ability to buy bonds that will provide a significant amount of money on the maturity date. This is particularly handy for retirement planning when investors have a small amount of money to put away, but need as much money as possible when the bond matures.
The tax consequences are the major drawback of OIDs. Although during the life of the bond, the investor does not receive interest payments, or receives very low payments, the portion of interest returned at maturity, along with principal, is amortized over the life of the bond. This means that the investors must report the amortized amount each year on their taxes and pay any income tax due on the amortized interest, despite the fact that they won't receive it for years.
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