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What is an original issue discount?
An original issue discount (OID) is when companies sell bonds at a discount to their face value. Bonds are sometimes sold for a price that is less than its stated value at maturity; the difference is the OID, which becomes additional interest income that accrues to the buyer if she holds it to maturity.
When interest rates are high, companies that would like to sell bonds face the prospect of being stuck with high interest payments over the life of the bond. Interest rates eventually decline, and longer-life, high-interest bonds can potentially burden the issuer’s cash flow with above-market-rate payments. Selling long-maturity, low-coupon or zero-coupon bonds at a discount solves this problem.
There are two types of OID bonds: Those that have a coupon and those that don’t. OID bonds that include a coupon provide investors with regular interest payments but have a price that is below the face value of the bond. OIDs without a coupon are called a zero-coupon bonds, and the discount is usually equal to the yield to maturity, or the amount that would have been paid out in interest over the life of the bond in interest payments.
From the perspective of the holder, an OID bond offers higher profits with a lesser investment involved. Some OID investors reinvest their discounted coupon payments at the higher market interest rates, further boosting their returns. For retirement planning, zero-coupon OID bonds provide a great way for holders that do not require periodic interest payments to earn higher profits at maturity.
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Original issue discount example
In the 1980s, Omni Consumer Products had been looking to raise debt funding, but stagflation and economic crisis had driven inflation and interest rates through the roof. In an effort to avoid burdening its longer-term cash flow with high interest rates down the road, Omni decided to issue 30-year OID bonds. They had a face value of $1,000 and a 5% coupon, or interest rate. Although this interest rate was well below the market rate at the time, investors got a discount on the face value of the bonds at purchase that made up the difference. It was a win-win: Omni avoided being stuck paying a high rate when market rates inevitably declined, and investors get a discount.