Original Issue Discount (OID) is the discount from par value at the time a bond or similar debt instrument is first issued. In simpler terms, it's the difference between a bond's stated redemption price at its maturity date (its face value) and a lower price for which it was originally sold by the issuer. This discount is a clever way of paying interest. Instead of sending you regular interest checks (known as coupon payments), the issuer gives you the entire interest payment in one lump sum at the end by repaying a price higher than you initially paid. The most famous example of an OID instrument is the zero-coupon bond, which pays no periodic interest at all. Instead, its entire return comes from the difference between its discounted purchase price and its full face value at maturity. While this sounds like a straightforward way to earn interest, tax authorities have a special and very important way of looking at this “unseen” income.
Imagine your favorite coffee shop offers a special deal: you can buy a $100 gift card today for just $80. You've essentially locked in a $20 gain. You don't get that $20 in cash right away, but you know that when you eventually use the card, you'll get $100 worth of coffee for your $80 investment. An OID bond works much the same way.
This structure provides a predictable return, a feature highly appreciated by cautious investors.
Here's the crucial catch that every investor must understand. Tax agencies, like the Internal Revenue Service (IRS) in the United States, don't let you wait until maturity to pay tax on that $200 gain. They see the OID not as a lump-sum payment at the end, but as interest that you earn gradually over the life of the bond. This process of gradually recognizing the interest is called accretion. This means that each year, a portion of the total OID is considered taxable income, even though you haven't received a single dollar in cash. This is famously known as phantom income because it appears on your tax return but not in your bank account.
Let's say you buy a 10-year, $1,000 face value zero-coupon bond for $800. The total OID is $200. Using a simplified method, the IRS might consider you to have “earned” $20 of interest each year ($200 OID / 10 years). You would have to report this $20 as income and pay tax on it annually. (The actual IRS calculation uses a more complex “constant yield” method, but the principle is the same).
To prevent you from being taxed twice on the same money, the amount of OID you report as income each year is added to your cost basis in the bond. So, after year one, your cost basis in the bond from our example would be $820 ($800 + $20). By the time the bond matures, your cost basis will have grown to $1,000. When you receive the $1,000 redemption payment, you will have no capital gain to report, because your cost basis equals the proceeds.
A savvy value investor analyzes an investment from all angles, especially its return profile and tax efficiency. Here’s how OID stacks up.
OID instruments, especially government securities like Treasury Bills (T-bills), offer a locked-in Yield to Maturity (YTM). This predictability is a huge plus, aligning with the value investing principle of ensuring a margin of safety and avoiding speculation. However, the phantom income feature makes them highly tax-inefficient when held in a standard, taxable brokerage account. Paying taxes on income you haven't received is a drag on your compounding power.
The phantom income problem has a simple solution: hold OID bonds in tax-advantaged retirement accounts, such as an IRA or 401(k) in the U.S. or similar tax-sheltered wrappers in Europe. Inside these accounts, the annual phantom income accretion is not taxed, allowing your investment to grow unhindered until you withdraw funds in retirement. This strategic placement turns a tax-inefficient asset into a powerful, predictable growth engine.
It's important to distinguish OID from a “market discount.” A market discount occurs when a bond that was not originally issued at a discount is later bought on the secondary market for a price below its face value (perhaps because interest rates have risen). Market discounts have different, and sometimes more favorable, tax rules than OID. The key is in the name: Original Issue Discount.