Market Discount refers to the difference between a bond’s face value and its trading price in the secondary market when the bond is sold for less than its original issue price. This is distinct from the original issue discount (OID) which occurs when a bond is initially issued at a price below its face value.
Understanding Market Discount
Definition and Characteristics
Market Discount occurs when bonds are sold in the secondary market for less than their face value. This situation commonly arises due to various factors such as rising interest rates, credit rating downgrades, or broad market conditions. Bonds that experience a market discount offer investors the potential for higher yields, as the purchase cost is lower than the bond’s face value.
Calculation of Market Discount
Market Discount can be calculated as:
For example, if a bond with a face value of $1,000 is currently trading at $950 in the secondary market, the market discount is $50.
Special Considerations
- Tax Implications: Market Discount is subject to specific tax treatments according to the IRS. If a bond purchased at a market discount is held until maturity, the discount is treated as ordinary income rather than capital gains.
- Investor Yield: Purchasing bonds at a market discount can increase an investor’s yield. This occurs because the yield to maturity (YTM) will be higher than the stated coupon rate due to the lower purchase price.
- Interest Rate Movements: Market Discount usually widens when interest rates rise since new bonds would be issued with higher coupon rates, making existing bonds with lower coupons less attractive unless priced at a discount.
Comparisons with Original Issue Discount (OID)
While both Market Discount and Original Issue Discount (OID) represent situations where bonds are sold for less than their face value, they differ in timing and origin:
- Market Discount: Occurs in the secondary market post-issuance.
- OID: Occurs at the time of bond issuance.
Examples of Market Discount
Consider a corporate bond with a face value of $1,000, a 5% coupon rate, and 10 years to maturity. If due to increasing interest rates, the bond’s price falls to $900, the $100 difference is the market discount. An investor buying this bond will receive interest based on the $1,000 face value and can expect to earn an additional $100 if held to maturity as the bond price converges to its face value.
Market Discount and Investment Strategies
Investors can capitalize on market discounts through various strategies:
- Holding to Maturity: Investors can purchase discounted bonds and hold them until maturity to realize the full face value.
- Trading: Investors can sell discounted bonds if market conditions improve, potentially realizing capital gains.
Related Terms
- Yield to Maturity (YTM): The total return anticipated on a bond if the bond is held until it matures.
- Coupon Rate: The annual coupon payment made by the bond issuer relative to the face value or principal.
- Secondary Market: The market where previously issued securities are traded among investors.
FAQs
What causes Market Discount?
How is Market Discount taxed?
Can Market Discount be advantageous?
References
- IRS.gov, “Publication 550 (Investment Income and Expenses),” which provides detailed guidelines on how market discount is taxed.
- Financial Industry Regulatory Authority (FINRA) materials on bond investments and market behavior.
Summary
Market Discount represents the difference between a bond’s face value and its trading price when sold for less than its original issue price. Understanding market discount involves recognizing its causes, tax implications, and potential advantages for investors. By comprehending these factors, investors can make informed decisions about purchasing and holding discounted bonds.
