Market Discount What it Means How it Works

Market Discount What it Means How it Works

Market Discount: Meaning and Function

What Is a Market Discount?

A market discount is the difference between an asset’s stated redemption price and its lower price in the secondary market. For fixed-income securities, a market discount exists if it trades below par value. Market discounts arise when the asset’s value on the secondary market decreases after issuance, usually due to rising interest rates. However, a discount can also result from a reduction in credit rating, increased perceived risk, or regulatory/legal action.

In the case of original issue discount (OID) securities like zero-coupon bonds, the market discount is the initial difference between the purchase price and the issue price plus accrued OID.

Key Takeaways

  • A market discount refers to an asset trading below its stated value on the secondary market.
  • Most often applied to bonds below par value, market discounts can arise due to changes in interest rates or other factors affecting risk perception.
  • Discounts on bonds are not taxable by themselves, but become taxable interest upon bond maturity (unless the discount is considered de minimus).

Understanding Market Discounts

While any asset or security can trade at a market discount, the term most often applies to fixed-income securities, particularly bonds. A bond sold at par (face value) has a coupon rate equal to the prevailing interest rate. Investors purchasing this bond have a return determined by periodic coupon payments. The bond discount is the difference between a bond’s market price and its face value.

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A premium bond has a market price higher than the face value. If a bond’s stated interest rate exceeds the expected rate in the bond market, it becomes an attractive option for investors.

A bond issued at a discount has a market price below the face value, presenting the potential for capital appreciation upon maturity.

Taxes and Discounts

A market discount on a bond is not subject to annual taxation in the U.S., but it is taxed as ordinary interest income upon sale or redemption. Bond investors can choose to include amortized market discount in their annual income for tax purposes, thus paying taxes currently instead of in the future. Note that market discount remains taxable even if regular interest income on the bond is tax-exempt, such as with municipal securities.

For example, let’s assume a U.S. investor buys a bond for $900, originally issued with a par value of $1,000. The $100 difference between the par value and the purchase price represents the market discount. This discount must be reported as ordinary interest income on the investor’s tax return upon disposition or on an amortized basis annually, depending on their choice.

Special Considerations

Exceptions exist for certain elections, such as U.S. savings bonds and short-term obligations maturing within a year of issue. Additionally, for tax-exempt bonds purchased before May 1, 1993, a gain resulting from a market discount is treated as a capital gain rather than interest income.

Another exemption applies to the treatment of market discount for tax purposes, known as the "de minimis" rule. Under this rule, if the discount upon purchase is less than 0.25% of the bond’s face value multiplied by the number of full years to maturity, the market discount is considered effectively zero. If the market discount is below the de minimis amount, it will be treated as a capital gain, rather than ordinary income, upon bond sale or redemption.

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For example, purchasing a $1,000 par value bond maturing in 10 years for $985 results in a market discount of $1,000 – $985 = $15. As this discount is less than the de minimis threshold of $25 (0.25% of $1,000 x 10 = $25), the market discount is considered zero. Consequently, the $15 discount will be treated as a capital gain when the bond is sold or redeemed.

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