Market Discount

  

Categories: Trading

“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

00:00

Finance allah shmoop what is a deep discount bond d

00:08

like down here where the whales go for a bit

00:11

of peace and quiet Look around thirty two cents on

00:14

the dollar twenty three cents on the dollar Ah and

00:17

here's a twelve center peace quiet so way up there

00:22

Yeah at the surface where the flying things hang out

00:25

a lot you know up there that's par one hundred

00:28

cents on the dollar crowd but down here lives the

00:31

deep discount bond crowd and we have our own set

00:34

of rules So who are we Well we're the shipwrecks

00:37

the fallen overboard phone companies that didn't work where Puerto

00:42

rico and where Greece where the failed the losers les

00:46

miserables well this guy used to yield five percent Now

00:50

he trades for just twenty cents on the dollar He's

00:52

so angry because well he thinks he should be up

00:55

there on the surface at par But no the street

00:58

has thrown him out and well he sank No michael

01:01

phelps there they don't believe that newspapers on paper are

01:05

ever going to be a thing again So ironically they

01:08

don't even want his paper sad while he thinks he's

01:11

a big bargain He's Still paying his coupon five cents

01:15

on the hundred cents on the dollar schedule five percent

01:18

Yeah only now you khun by that five cents a

01:20

year for one fifth of the price Twenty cents That's

01:24

right twenty cents for a dollar of par or you

01:27

get five times the yield Yep five times five percent

01:31

yield or twenty five percent When you're buying that one

01:33

hundred cents on the dollar our value for only twenty

01:36

cents Yeah crazy high yield if he pays if it

01:39

continues to yield the alec he may stop We don't

01:42

know Well oops Here comes another Who a ten cent

01:45

on the dollar ouch coupon here is six percent So

01:47

the yield well if it pays is now sixty percent

01:51

crazy crazy high and clearly nobody believes the coupons going

01:55

keep in there but deep discount bonds down here have

01:57

another strange thing that people wake up They're in the

02:00

sun shining land of par Don't think about appreciation meaning

02:04

that well let's say that sears reinvents itself and becomes

02:07

a coffee selling kid love an amusement park and the

02:11

ten cent on the dollar bonds which paid sixty percent

02:14

Yield Now Yeah here's the math Well what happens if

02:17

they go all the way back up to par Well

02:20

you've made your interest of course but you'll also make

02:23

a ten times the money on the investment yourself right

02:26

invested a dime and go back to pa ra tha

02:29

dollar well And then everyone will be singing singing under

02:33

the park under the par do dahlia under the sea 00:02:36.728 --> [endTime] and forget that

Up Next

Finance: What is Discounted Cash Flow?
9 Views

What is Discounted Cash Flow? Discounted Cash Flow is a model that’s used to determine the value of an investment or company. It’s pretty compl...

Finance: What is the Dividend Discount Model?
2 Views

What is the Dividend Discount Model? Valuation of stocks can take numerous forms. One way in which one perspective on undervalued stocks is determi...

Find other enlightening terms in Shmoop Finance Genius Bar(f)