Investments, tenth edition

 Example  14.10 

Taxation of Original-Issue Discount Bonds 

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P A R T   I V

 Fixed-Income 

Securities

  The procedure illustrated in Example 14.10 applies as well to the taxation of other 

original-issue discount bonds, even if they are not zero-coupon bonds. Consider, as an 

example, a 30-year maturity bond that is issued with a coupon rate of 4% and a yield to 

maturity of 8%. For simplicity, we will assume that the bond pays coupons once annually. 

Because of the low coupon rate, the bond will be issued at a price far below par value, 

specifically at $549.69. If the bond’s yield to maturity is still 8%, then its price in 

1 year will rise to $553.66. (Confirm this for yourself.) This would provide a pretax 

holding-period return (HPR) of exactly 8%:   

HPR

5

$40

1 ($553.66 2 $549.69)

$549.69

5 .08  

 The increase in the bond price based on a constant yield, however, is treated as interest 

income, so the investor is required to pay taxes on the explicit coupon income, $40, as well 

as the imputed interest income of $553.66  2  $549.69  5  $3.97. If the bond’s yield actually 

changes during the year, the difference between the bond’s price and the constant-yield 

value of $553.66 would be treated as capital gains income if the bond is sold. 

 Suppose that the yield to maturity of the 4% coupon, 30-year maturity bond falls to 7% by the end of the 

first year and that the investor sells the bond after the first year. If the investor’s federal plus state tax rate 

on interest income is 38% and the combined tax rate on capital gains is 20%, what is the investor’s after-

tax rate of return? 

 CONCEPT CHECK 

14.7 

        14.5 

Default Risk and Bond Pricing 

  Although bonds generally  promise  a fixed flow of income, that income stream is not risk-

less unless the investor can be sure the issuer will not default on the obligation. While U.S. 

government bonds may be treated as free of default risk, this is not true of corporate bonds. 

Therefore, the actual payments on these bonds are uncertain, for they depend to some 

degree on the ultimate financial status of the firm. 

 Bond default risk, usually called    credit  risk    ,  is measured by Moody’s Investor Services, 

Standard & Poor’s Corporation, and Fitch Investors Service, all of which provide finan-

cial information on firms as well as quality ratings of large corporate and municipal bond 

issues. International sovereign bonds, which also entail default risk, especially in emerg-

ing markets, also are commonly rated for default risk. Each rating firm assigns letter 

grades to the bonds of corporations and municipalities to reflect their assessment of the 

safety of the bond issue. The top rating is AAA or Aaa, a designation awarded to only 

about a dozen firms. Moody’s modifies each rating class with a 1, 2, or 3 suffix (e.g., 

Aaa1, Aaa2, Aaa3) to provide a finer gradation of ratings. The other agencies use a  1   or   2  

modification. 

 Those rated BBB or above (S&P, Fitch) or Baa and above (Moody’s) are considered 

   investment-grade  bonds    ,  whereas lower-rated bonds are classified as