The issue price of a bond is the dollar amount investors pay when the bond is first sold to the public. Under federal tax law, for a publicly offered bond sold for cash, that price is the initial offering price at which a substantial number of the bonds in the issue were actually sold to buyers other than brokers and underwriters.1Office of the Law Revision Counsel. 26 USC 1273 – Determination of Amount of Original Issue Discount Whether that price ends up at, below, or above the bond’s face value drives both how much capital the issuer raises and how the bondholder is taxed each year.
If a bond is exchanged for property instead of cash, a separate set of rules under Section 1274 generally sets the issue price using the present value of the payments due on the instrument. Most investors buying a newly issued bond through an offering are working under the cash rule above.
Par, Discount, and Premium
A bond’s stated interest rate (its coupon) is fixed when the issue is designed. The market rate for bonds of comparable risk and maturity moves independently. The issue price is what closes the gap between the two.
When the coupon matches what the market demands, the bond is issued “at par” — the issue price equals the face value, typically $1,000 per bond. A $1,000 bond with a 5% coupon in a 5% market sells for $1,000. The investor’s return comes entirely from the coupon payments, and there is no built-in gain or loss from the pricing itself.1Office of the Law Revision Counsel. 26 USC 1273 – Determination of Amount of Original Issue Discount
When the coupon is below the market rate, the issuer has to sweeten the deal by lowering the price. A $1,000 bond with a 3% coupon in a 4% market might be issued at $950. The investor collects the below-market coupon along the way and receives the full $1,000 at maturity; that $50 gap is what pulls the total yield up to what the market requires. The tax code calls that gap original issue discount, or OID: the excess of the stated redemption price at maturity over the issue price.1Office of the Law Revision Counsel. 26 USC 1273 – Determination of Amount of Original Issue Discount
When the coupon is above the market rate, investors compete for the extra income and drive the price above face value. A $1,000 bond paying 6% in a 4% market might be issued at $1,050. The investor overpays upfront and only gets $1,000 back at maturity, but the above-market coupons make up the difference. That $50 overpayment is the bond premium.
What Moves the Price
The dominant factor is the coupon-to-market-rate gap described above. Several inputs feed into what the market rate is for any particular bond.
Credit quality is one. Rating agencies assess how likely the issuer is to make every promised payment on time; a lower rating signals higher default risk, and investors demand a larger return for taking on that risk, which pushes the issue price down. Maturity is another. A 30-year bond carries more uncertainty about inflation and future conditions than a 5-year bond, and the price reflects that.
Underwriters use current U.S. Treasury yields as the baseline for corporate and municipal bonds. The gap between a bond’s yield and the Treasury yield for the same maturity is the credit spread, and it captures the extra return investors want for going beyond a government-backed security. Issuer financials, offering size, and investor appetite on the pricing date all move that spread.
How the Issue Price Is Calculated
The price is the sum of two present-value calculations. The face value — a single lump sum paid at maturity — is discounted back to today using the market interest rate. The stream of coupon payments is discounted back to today using the same rate. Add the two, and you have the bond’s price.
Mechanically, each future coupon is divided by (1 + market rate) raised to the power of the period it arrives in, and the face value is discounted the same way for the final period. When the market rate equals the coupon, the math produces exactly face value. When the market rate is higher, future cash flows are worth less today and the price falls below par. When it is lower, the price rises above par.
A worked example: a 5-year, $1,000 bond with a 5% annual coupon, priced against a 5% market rate. Each $50 coupon and the final $1,000 principal, discounted at 5%, add up to exactly $1,000. Raise the market rate to 6% and the same cash flows are worth about $958 today, a discount. Drop the market rate to 4% and the price climbs to roughly $1,045, a premium.
Tax Consequences When a Bond Is Issued at a Discount
OID is treated as interest for federal tax purposes. A bondholder generally has to include a portion of the discount in gross income each year, using a constant-yield method that reflects how the bond’s value grows toward face value over time.2Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount The daily OID is figured by allocating to each day its share of the increase in the bond’s adjusted issue price during the accrual period. The compounding means the amount pulled into income is smaller in the early years and larger later on.
The catch: this tax hits before the cash arrives. The bondholder owes tax each year on OID even though the discount is not actually paid out until the bond matures or is sold. Issuers and brokers report the annual amount on Form 1099-OID when the includible discount is at least $10 for the year.3Internal Revenue Service. About Form 1099-OID, Original Issue Discount
The De Minimis Rule
Small discounts are exempt from annual accrual. If the total OID on a bond is less than one-quarter of 1% of the face value multiplied by the number of complete years to maturity, the discount is treated as zero for OID purposes.1Office of the Law Revision Counsel. 26 USC 1273 – Determination of Amount of Original Issue Discount For a 10-year, $1,000 bond, the threshold is $25 (0.25% × $1,000 × 10). If the bond’s total OID falls below that, the holder skips the annual accrual and instead reports the discount as a capital gain when the bond matures or is sold.4Internal Revenue Service. Publication 1212, Guide to Original Issue Discount (OID) Instruments
Zero-Coupon Bonds
Zero-coupon bonds take the discount structure to its extreme. They pay no periodic interest at all; the entire return is the gap between the discounted purchase price and the face value at maturity. A 10-year zero-coupon bond with a $1,000 face value and a 3% yield compounded semiannually would be issued at roughly $742.4Internal Revenue Service. Publication 1212, Guide to Original Issue Discount (OID) Instruments
The full $258 gap is OID and accrues annually under the same constant-yield rules. That means the holder owes tax each year on interest they will not see in cash for a decade. Because of that phantom income problem, zero-coupon bonds are often held in tax-deferred accounts like IRAs, where the annual accrual does not produce a current tax bill.
Tax Consequences When a Bond Is Issued at a Premium
An investor who pays a premium can elect to amortize it, reducing reported interest income each year by the portion of the premium allocated to that period. The allocation uses a constant-yield method similar to the OID rules.5eCFR. 26 CFR 1.171-1 – Bond Premium
To make the election, the bondholder offsets interest income with the bond premium on a timely filed federal return for the first year the election is to apply and attaches a statement indicating the election is being made.6eCFR. 26 CFR 1.171-4 – Election to Amortize Bond Premium on Taxable Bonds One important limit: the election applies to all taxable bonds the holder owns during or after that tax year. It cannot be turned on for a single bond and off for another. Without the election, the investor pays tax on the full coupon each year and only claims the premium as a loss when the bond matures or is sold.
Where to Find the Issue Price
Federal securities law requires the issue price to be disclosed before the bond reaches the buyer. The Securities Act of 1933 requires the registration statement to include the proposed offering price, or the method used to calculate it, along with any price variations offered to different classes of buyers.7GovInfo. Securities Act of 1933 SEC prospectus rules go further: the outside front cover page of the prospectus must display the price to the public, the underwriter’s discount, and the net proceeds the issuer receives.8eCFR. 17 CFR 229.501 – Outside Front Cover Page of Prospectus Anyone looking to confirm a specific bond’s issue price should start with the prospectus front cover.