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.
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.
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.
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
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.
There are advantages to putting capital in original discount bonds, including:
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:
There are factors to consider when mulling investing in OID bonds, chiefly:
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.
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.
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.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.