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BOND MATH: The Theory Behind the Formulas by Donald J. Smith

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Original Issue Discount Bonds

A zero-coupon bond is treated quite differently from a standard coupon bond in terms of timing but not character. In particular, zeros fall under the rules for original issue discount (OID) securities. A bond is designated OID if the issuance price is lower than the de minimis threshold. Therefore, a bond is deemed to be OID if the discount is more than 0.25 times the number of years to maturity. A 10-year corporate zero priced at 60 (percent of par value) easily passes that test—as would any 10-year, low-coupon bond, issued at a price below 97.5.

The key tax aspect of an OID bond is that the yearly movement along the constant-yield price trajectory is the reported ordinary interest income to the investor and interest ...

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