Original Issue Discount: How to Get Cheaper Bonds

Key Takeaways

• Original issue discount bonds are those that, upon original issuance, were sold at a press under their par amounts, with the differences being the OID amounts.

• With original issue discounts, the process calls for the issuer to give the lender a fee in the form of an OID. The investor gets the interest income based on the coupon payment, and upon maturity, the face value is paid to the investor. 

• The market will usually demand a higher yield on highly discounted OID bonds than on those of equal maturity without an original issue discount and higher stated interest payments.

One feature of debt financing is called original issue discount (OID), in which an issuance price is lower than the stated redemption price. Often offered as a “deal sweetener,” OIDs can mean higher bond yields. However, they are not for every investor.

That said, here is what should be known about original issue discounts — and getting cheaper bonds.

What is an Original Issue Discount (OID) Bond?

An OID is usually recreated when a debt – typically a bond – is issued at a discount.  In other words, these are bonds that, upon original issuance, were sold at a press under their par amounts, with the differences being the OID amounts.

How an Original Issue Discount Bond Works

For the bondholder, the OID’s purpose is to serve as extra-interest income that they receive at the end, plus the interest payments they receive over the bond’s life. While the investor may receive less than face value up top, they will receive more than they paid for upon bond maturity.

With some bonds, including zero-interest bonds, the original issue discount is the sole interest the investor will earn.

To illustrate, Construction Company A has an upcoming project, for which it must raise capital. So, it issues bonds. The debt securities – zero-coupon bonds – have a $100 face value. Initially, the company sells the bonds at $85 each, and Annette buys one. The bonds are zero coupon, meaning Annette and the other bondholders will not receive interest payments over the life of the bond. However, upon bond maturity, Annette will get $100 from the construction firm.  Because she paid just $85 for the bond, she profits $15.

In another example, say a firm hopes to raise $100,000 in the form of debt.

To render the financing more attractive to prospective lenders, the company proposes to accept $98,000 in capital in lieu of the whole $100,000. But when the maturity date arrives, the borrower still must repay the entire $100,000, in addition to the periodic interest expense, which is based on the $100,000 principal and the stated interest rate.

From the borrower’s perspective, because the debt is issued at a discount to the par value — $98,000 – the borrower gets 98 cents for every dollar owed.

From the bondholder’s perspective, the investor had to come up with only $98,000 but gets $100,000 upon maturity with interest payments based on the whole principal rather than the actual financing total.

With this illustration, with the debt with a $100,000 par value selling for $98,000, the original issue discount is $2,000.  

How to Calculate the OID

The original issue discount formula is the difference between the stated redemption price and the issuance price:

Original Issue Discount (OID) = Redemption Price – Issuance Price

where

• Redemption price:  the bonds’ “par value,” the amount that must be returned on the maturity date.
• Issuance price: The offering price for which the bonds were sold on the sale date.

For a simple example, if a bond has a $100 face value, that means the investor gets $100 returned upon bond maturity. If the bond is bought for $95 and receives $100 at maturity, the original issue discount is $5 – the return on the investment.

Unlike with traditional bonds, the gain from the original issue discount is realized only upon maturity, when the investor gets the face value principal’s return. So, in effect, the discount is paid as an overall total at maturity, plus the original investment amount.

Benefits of Investing in Original Issue Discount Bonds

There are advantages to putting capital in original discount bonds, including:

• Potential for capital appreciation. The OID amount that accrues during compounding but is not paid is effectively automatically reinvested at the compounding period’s end in the same bond at the same return as the original investment. Should market rates drop, the automatic reinvestment prompts the OID bond to rise in value quicker than a comparable bond that has no OID. Here, the holder may only reinvest interest payments at the lower returns then available in the market.
• Potential for higher yields. Particularly when it comes to highly discounted OID bonds, the market will usually demand a higher yield on those bonds than on those of equal maturity without an original issue discount and higher stated interest payments. Sometimes, the market-demanded yield is markedly higher.

OID Bonds vs. Other Bond Types

With original issue discount bonds, the OID serves as additional interest income the bondholder receives at the end, plus the interest payments received during the life of the bond. That contrasts with bonds including:

• Zero coupon bonds.  With these bonds and some others, the OID is the sole interest the bondholder will earn from the investment. 
• Junk bonds. These bonds potentially offer higher yields than investment-grade bonds but are riskier. Also, when yields increase, it becomes pricier for issuers to borrow in the bond market. 

Risks and Considerations of Investing in OID Bonds

There are factors to consider when mulling investing in OID bonds, chiefly:

• Interest rate changes. A company may have a bond that sells at a face-value discount but also pays periodic interest. The issue is that the amount of original issue discount usually corresponds with the bond’s rate inversely. This generally means that the larger the discount, the lower the offered bond coupon rate.
• Short-term investment goals. It does take time for the investor to earn their bond discount as it accretes to its face value, offering a form of interest.

How Investors Can Make Money Through OID’s

With original issue discounts, the process calls for the issuer to give the lender a fee in the form of an OID. The investor gets the interest income based on the coupon payment, and upon maturity, the face value is paid to the investor. 

For many investors, the potential for capital appreciation and higher yields are enticing. And there are multiple ways investors can earn income with original issue discounts, including through private credit offerings such as those provided by Yieldstreet.

The leading alternative investment platform Yieldstreet, which focuses on generating passive income for investors, offers the broadest selection of alternative asset classes, including art, real estate, legal finance – and private credit. 

Investors on Yieldstreet’s platform can access private credit through curated individual private debt offerings or selected private debt funds backed by top private credit fund managers carefully selected by Yieldstreet. As with any investments, there are risks in the private credit space. However, such opportunities can produce portfolio income.

Alternative Investments and Portfolio Diversification

In addition to potentially attractive returns and protection against inflation, private credit also serves another purpose, and that is to help diversify one’s investment portfolio. Diversification – crafting one’s holdings to include varying asset classes and types – is key to long-term successful investing.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

While OIDs are susceptible to interest rate changes and are really only suitable for short-term investment goals, they can offer better yields, in addition to capital appreciation. Remember, though, that there are other ways to make money through original issue discounts, including through private debt offerings that also diversify.