“Oh boy,” we exclaim, rubbing our hands together gleefully. We just bought a bond for $600 that was originally issued for $1,000. What a steal, what a deal.
When this happens—when there’s a difference between a bond’s sale price and its redemption price—that’s what’s known as a “market discount,” and discounts like these can make the savvy investor nice little chunks of change.
But buyer beware: market discounts come with more tax rules than a convoluted D&D game. For example, that $400 we saved on that bond purchase? We need to report it as interest income and pay the applicable taxes on it. Unless the bond was issued prior to 1993, in which case we need to pay capital gains taxes on it instead. Or, if it’s a United States savings bond we’re talking about, it's exempt. No tax payment needed. Or, if the market discount is less than .25% of the bond’s value—that’s point two-five, not twenty-five percent, BTW—then we don’t have to claim it as interest income, but we do have to claim it as capital gains.
Why so confusing? Because taxes, that’s why. So if we’re planning on making an investment career out of market discounts (which is probably not advisable), we should find ourselves a tax accountant who can help us sort through it all and keep us on the right side of the IRS.
Related or Semi-related Video
Finance: What is a Deep Discount Bond?13 Views
Finance allah shmoop what is a deep discount bond d
like down here where the whales go for a bit
of peace and quiet Look around thirty two cents on
the dollar twenty three cents on the dollar Ah and
here's a twelve center peace quiet so way up there
Yeah at the surface where the flying things hang out
a lot you know up there that's par one hundred
cents on the dollar crowd but down here lives the
deep discount bond crowd and we have our own set
of rules So who are we Well we're the shipwrecks
the fallen overboard phone companies that didn't work where Puerto
rico and where Greece where the failed the losers les
miserables well this guy used to yield five percent Now
he trades for just twenty cents on the dollar He's
so angry because well he thinks he should be up
there on the surface at par But no the street
has thrown him out and well he sank No michael
phelps there they don't believe that newspapers on paper are
ever going to be a thing again So ironically they
don't even want his paper sad while he thinks he's
a big bargain He's Still paying his coupon five cents
on the hundred cents on the dollar schedule five percent
Yeah only now you khun by that five cents a
year for one fifth of the price Twenty cents That's
right twenty cents for a dollar of par or you
get five times the yield Yep five times five percent
yield or twenty five percent When you're buying that one
hundred cents on the dollar our value for only twenty
cents Yeah crazy high yield if he pays if it
continues to yield the alec he may stop We don't
know Well oops Here comes another Who a ten cent
on the dollar ouch coupon here is six percent So
the yield well if it pays is now sixty percent
crazy crazy high and clearly nobody believes the coupons going
keep in there but deep discount bonds down here have
another strange thing that people wake up They're in the
sun shining land of par Don't think about appreciation meaning
that well let's say that sears reinvents itself and becomes
a coffee selling kid love an amusement park and the
ten cent on the dollar bonds which paid sixty percent
Yield Now Yeah here's the math Well what happens if
they go all the way back up to par Well
you've made your interest of course but you'll also make
a ten times the money on the investment yourself right
invested a dime and go back to pa ra tha
dollar well And then everyone will be singing singing under
the park under the par do dahlia under the sea 00:02:36.728 --> [endTime] and forget that
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