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Let's start with the character of the cash flows on a standard coupon bond. Suppose that a corporation issues a 4%, annual payment, 4-year note at a price of 99.342 (percent of par value). Remember from Chapter 3 that the yield to maturity on this bond is 4.182%. Each year, the investor has taxable ordinary interest income in the amount of $40 per $1,000 of par value, and the issuer has equivalent ordinary interest expense. Importantly, that interest expense is deductible for the corporate issuer, creating the well-known tax advantage to debt financing compared to equity.

If the investor holds the bond to maturity and redeems it at par value or sells the bond prior to maturity at a price above 99.342, will there be a capital gain for tax purposes? If it is sold at a price below 99.342, will there be a capital loss? This is where bond taxation starts to get interesting. Back in the olden days (i.e., before 1984), bonds essentially were taxed like equity. Interest payments on debt securities, like dividend payments on stocks, were treated as ordinary income. The purchase price of the bond or stock was the basis for determining capital gains or losses when the security was sold or redeemed. The rule of thumb always has been that investors prefer capital gains to ordinary income because usually they are taxed at a lower rate. That is one of the motives for stock-repurchase programs in lieu of cash dividends – to return value to investors in a tax-favored manner.

The high market interest rates prevailing in the 1980s motivated the federal government to change the tax rules for bonds. Look again at Figure 2.1 in Chapter 2. Because yields had gone up, bonds that had been issued a few years earlier invariably were trading at discounts below par value. A bond newly issued at par value would require higher coupon payments, all of which would be taxed as ordinary income. Instead, the investor could buy a discount bond having a lower coupon rate. If held to maturity, that discount then would be taxed at the lower capital gains rate.

In principle, interest payments are compensation to the investor for the passage of time, scaled by the amount of credit and liquidity risk on the underlying debt obligation. Moreover, in principle, capital gains and losses arise from a change in the value of the bond as signaled by a change in its yield to maturity. The government realized that an investor who buys a bond at a discount and holds it to maturity does not necessarily merit a capital gain. The bond price is “pulled to par” as time passes, but that is not a change in value. In theory, the difference between the purchase price and the redemption amount is just interest income and should be taxed at the ordinary income rate, albeit deferred. The big change in bond taxation in 1984 had to do with character, not timing. Buying a bond issued before 1984 at a discount would generate a capital gain if held to maturity. On a bond issued after 1984, that “gain” would be taxed as ordinary income. The examples to follow should clarify this.

Our 4%, 4-year bond issued at 99.342 has an original issue discount (OID) of 0.658 (percent of par value). But the discount on this bond is so small that it qualifies as de minimis OID. Technically, the criterion for de minimis OID treatment is that the discount at issuance is less than the number of the years to maturity times 0.25. If the initial price on this 4-year bond had been less than 99 (percent of par value), it would not be designated as de minimis OID and instead would merit special OID tax treatment to be discussed later in the chapter. So, if the investor holds the bond to maturity, there will be a capital gain of 0.658 (percent of par value) taxable at redemption, just like in the olden days.

We can now project an after-tax rate of return for this bond. Let's assume that the investor's ordinary income tax rate over the four years is constant at 25%, the capital gains tax rate is 15%, and all taxes are paid when cash flows are received. Notice how cavalierly we make simplifying assumptions to sidestep reality. The after-tax yield (aty) on this bond is 3.154%, the internal rate of return on the after-tax cash flows.

The first four terms on the right side of the equation are straightforward – the after-tax cash flow is 3.00 (percent of par value), the pretax coupon interest payment of 4 times one minus the ordinary income tax rate of 25%. In the fifth term, the gain of 0.658 (percent of par value) – that is, 100 – 99.342 = 0.658 – from purchasing the bond at a discount is taxed at the capital gains rate of 15%, and that tax obligation is subtracted from the redemption amount.

Newly issued bonds having de minimis OID are actually quite common in the U.S. Treasury market. That's because the auction process allows for noncompetitive bids. These, mostly from retail investors and small institutions, are limited in size – currently, the maximum non competitive bid is $5 million in par value. The competitive bids submitted by government securities dealers and big financial institutions determine the stop-out, or market-clearing, yield for the Treasury notes or bonds. Then the coupon rate is set to the nearest 1/8% below the stop-out yield. For example, if the stop-out yield is 2.415%, the coupon rate will be set at 2 3/8%; if the stop-out rate is 2.365%, the coupon rate will be 2 1/4%. Therefore, the price at issuance will be a small discount below par value. The noncompetitive bidders, who are assured of receiving their bid amount, initially pay full par value. At settlement, they receive a payment for the amount of the discount along with their securities. If instead the coupon rate had been set above the stop-out yield, the government would need to collect the premium. It's easier to just have a de minimis OID.

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