Discount Bonds

Sometimes bonds sell on the open market at a price substantially less than their par value. These bonds aren’t to be confused with originalissue discount bonds, which are sold at a price that is less than their face value at the time of issue. This is usually the result of rising interest rates, which cause bond prices to fall. These bonds are referred to as “market discount bonds.” Investors like these bonds for many rea- sons. One, market discount bonds grant the investor an automatic call protection since their coupon rates are relatively low when compared with current market interest rates. Two, the bond issuers must generally pay at least face value when the bond is redeemed, which would increase the issuer’s cost of the call. All types of bonds, including Treasury bonds and municipals, may be sold at deep discount. The accessibility to market discount bonds depends on the current interest rate. The more the interest rate rises, the more discount bonds you will be able to find; the reverse is also true.

For tax purposes, any gain between the market discount and the resulting value from the sale, redemption, or maturity of the bond will be taxed as ordinary interest income, instead of capital gains, as long as the taxable bonds were issued after July 18, 1984 or the bonds were issued on or before July 18, 1984 and purchased on the open market after April 30, 1993. If there is a gain greater than this amount, it will be taxed at capital gains tax rates. Likewise, any loss will be treated as a capital loss. For other taxable bonds, any gain from the sale, redemption or maturity of the bonds will be taxed at capital gains rates. For those cash-basis bondholders, an election may be made to include the accrued market discount each year in their gross income, and have it taxed annually. However, this usually doesn’t happen. If the investor has any unused interest expenses that may only be deducted against interest income, this choice would be helpful. Any tax-exempt market discount bonds (munis) that were purchased after April 30, 1993 and that had a gain between the market discount and the resulting value from the sale, redemption, or maturity of the bond will be taxed as ordinary interest income, instead of a capital gain.