An original issue discount or OID is any type of debt instrument that is issued at a price that is less than the face value of that instrument. This approach is sometimes used with bond issues, issuing the bonds below the face or par value, with the understanding that the bond will be honored at the par value once the instrument matures. One of the more common examples of bonds that are sold as original issue discounts are zero-coupon bonds.
The concept of an original issue discount is often traced to the latter half of the 20th century. During the 1970s and early 1980s, high interest rates in the United States and several other countries led to businesses and even some governments offering bonds that did not pay periodic interest, but would pay a credible return when the bonds reached full maturity. This effectively allowed the issuers to side-step the high interest rates for a period of time, with the anticipation that by the time the bonds did mature, interest rates would be at more manageable levels.
One of the best examples of an original issue discount is the zero-coupon bond. This type of bond does not have any type of stated interest rate at the time of the purchase. This means that the issuer does not make any interest payments to the bondholder during the life of the bond. Only once the bond reaches maturity does the investor realize a return on the investment.
A slightly different approach to the original issue discount is the non-zero deep discount bond. As with any type of OID, this bond arrangement is bought for less than the face or par value of the instrument. Unlike the zero-coupon bond, an investor who holds a non-zero deep discount bond will receive interest payments on some type of recurring basis throughout the life of the bond, usually annually or semi-annually.
For investors, the attraction of an investment that includes an original issued discount is the fact that the debt instrument can be purchased for considerably less than the face value. Over time, the opportunity to earn an equitable return is there, without the need to incur a great deal of risk. Assuming that the issuing entity is strong financially, and can be anticipated to remain strong for the entire life of the debt security, this type of investment is ideal for conservative investors.
Governments and businesses that issue debt instruments that are structured as OIDs also benefit. The approach is helpful when it comes to dealing with economic periods where interest rates are higher, in that the instrument can be set to mature at a time when the rates are likely to be lower. As a result, the issuer can plan on having the reserves on hand to honor the instruments as they mature without a great deal of difficulty.
There can be some drawbacks to the original issue discount approach. While zero coupon bonds are fairly straightforward, other debt instruments that are structured in this manner may be more problematic. For this reason, investors should look closely at the projected return over the life of the instrument, and determine if the risk and the sometimes more complicated tax structure that emerges from this type of investment activity is really worth the effort.
