What Is Original Issue Discount (OID) in Finance?

Original Issue Discount (OID) occurs when a debt instrument is issued at a price lower than its stated redemption price at maturity. This difference represents a form of implicit interest that the borrower pays to the lender over the instrument’s life.

Understanding Original Issue Discount

OID signifies the difference between a debt instrument’s face value and its original issue price. This discount functions as an additional form of interest earned by the investor. Unlike traditional bonds that pay regular cash interest, OID instruments embed interest into the discounted purchase price.

Investors receive this embedded interest when the bond matures, as they are paid the full face value, which is higher than their initial investment. This mechanism allows the issuer to raise capital at a lower upfront cost, while providing an attractive yield through the bond’s appreciation over time. The OID represents an implicit return on investment that accrues over the instrument’s life.

How OID is Created

OID primarily emerges from issuance structures designed to attract investors or reflect market conditions. Zero-coupon bonds are a straightforward instance; they do not pay periodic interest. Instead, these bonds are sold at a significant discount to their face value, and the entire return comes from receiving the full face value at maturity. The difference between the discounted issue price and face value constitutes the OID.

OID also occurs with bonds that feature a stated interest rate but are issued below face value. This typically happens when the bond’s coupon rate is lower than prevailing market rates. To make the bond competitive and appealing to investors, the issuer sells it at a discount, increasing its effective yield to maturity. This discount compensates investors for the lower stated interest payments and is a critical component of the bond’s overall return.

Accounting for OID

Accounting for OID involves systematically recognizing the discount as interest expense for the issuer and interest income for the holder over the debt instrument’s life. This process, known as amortization, ensures the instrument’s carrying value gradually increases from its issue price to its face value at maturity. The “constant yield method,” also called the effective interest method, is the standard accounting practice for amortizing OID.

Under this method, a consistent interest rate applies to the bond’s adjusted carrying value at the beginning of each accrual period. This approach accurately reflects the economic accrual of interest, even if no cash payments are exchanged. For the issuer, amortized OID is recorded as an interest expense, increasing the debt’s book value. Conversely, for the holder, the amortized OID is recognized as interest income, which also increases the bond’s basis.

Tax Considerations of OID

For holders of OID instruments, the Internal Revenue Service (IRS) generally requires accrued OID to be reported as taxable interest income each year, even if no cash payments are received until maturity. This is known as “phantom income” because investors pay taxes on income not yet physically received. This annual inclusion increases the bond’s tax basis, helping prevent double taxation when the bond is sold or matures. Brokers and other intermediaries typically report OID amounts to the IRS and to investors on Form 1099-OID.

From the issuer’s perspective, accrued OID is generally deductible as an interest expense over the debt instrument’s life. This deduction is allowed even without corresponding cash interest payments. The tax rules aim to align income and expense recognition with the economic reality of interest accruing over time.

Instruments Featuring OID

OID is found in various financial instruments. Zero-coupon bonds are a prominent example, where the entire interest return is embedded in the OID. U.S. Treasury STRIPS are common OID instruments.

OID can also be present in corporate bonds issued below par value. Mortgage-backed securities (MBS) and asset-backed securities (ABS) may feature OID components. Certificates of Deposit (CDs) with maturities exceeding one year that pay interest only at maturity can also be subject to OID rules. Some convertible or exchangeable debt instruments might also incorporate OID.