Market Discount

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 a fixed-income security, a market discount would exist on the off chance that it trades below par value. Market discounts arise when the asset's value on the secondary market decreases after it has been issued, as a rule in light of a rise in interest rates — yet a discount may likewise manifest as the outcome from a reduction in credit rating, increase in perceived risk, or regulatory or legal action that influences that asset.

On account of original issue discount (OID) securities, for example, zero-coupon bonds, the market discount is the initial difference between the purchase price and the issue price plus accrued OID.

Understanding Market Discounts

While any asset or security can trade at a market discount, the term most frequently applies to fixed-income securities, and especially to bonds. A bond sold at par (likewise called face value) has its coupon rate equivalent to the overall interest rate in the economy. An investor who purchases this bond has a return on investment that is determined by the periodic coupon payments. The bond discount is the difference by which a bond's market price is lower than its face value.

A premium bond is one for which the market price of the bond is higher than the face value. Assuming the bond's stated interest rate is greater than those expected by the current bond market, this bond will be an appealing option for investors.

A bond issued at a discount has its market price below the face value, making the potential for capital appreciation upon maturity since the higher face value is paid when the bond matures.

Taxes and Discounts

A market discount on a bond isn't subject to taxation every year in the U.S., yet it is taxable as ordinary interest income in the year that the bond is sold or redeemed. The bond investor can likewise choose to include amortized market discount every year in income for tax purposes, albeit this would mean paying tax on it now as opposed to from here on out. Note that market discount is taxable even assuming standard interest income from the bond being referred to is tax-exempt like it is for municipal securities.

For example, expect that a U.S. investor pays $900 for a bond that was originally issued with a par value of $1,000. The $100 difference between the par value and the purchase price is the market discount. This difference should be reported as ordinary interest income on the investor's tax return either upon disposition or yearly on an amortized basis, depending on the election made by the investor.

Special Considerations

There are certain exemptions for the election rules, for example, for U.S. savings bonds and for short-term obligations that mature in one year or less from the date of issue. Likewise, for tax-exempt bonds purchased before May 1, 1993, a gain emerging from a market discount is treated as a capital gain as opposed to interest income.

One more exemption to the election of how market discount ought to be treated for tax purposes connects with "de minimis" or small market discounts. Under the de minimis rule, the market discount is treated as really zero in the event that the amount of the discount upon purchase is under 0.25% of the bond's face value, duplicated by the number of full a very long time from the hour of purchase to the maturity date. On the off chance that the market discount is not exactly the de minimis amount, the market discount would need to be treated as a capital gain — as opposed to ordinary income — when the bond is sold or redeemed.

For instance, in the event that you buy a $1,000 par value bond developing in 10 years for $985, the market discount is $1,000 - $985 = $15. Since this discount is not exactly the de minimis threshold of $25 (0.25% of $1,000 x 10 = $25), the market discount is considered to be zero. Subsequently, the $15 discount will be treated as a capital gain when you sell or redeem the bond.

Features

• Most frequently applied to bonds that trade below par value, market discounts can arise due to changes in interest rates or different factors that influence its risk discernment.
• A market discount alludes to an asset that is trading below its stated value on the secondary market.
• Discounts on bonds are not taxable in an of themselves, but rather will be owed as taxable interest when the bond matures (except if the discount is considered de minimus).