Interest on bonds is conceptually straightfoward, though not simple. Even though the detailed calculations can be a bit of a nightmare.
When one buys a bond from an issuer, one is buying a fixed rate of interest for the life of the bond (until maturity or call). That interest may be paid periodically or when the bond is redeemed (bought at one price and redeemed at a higher price at maturity, like a CD) or a combination of both. Regardless of the form the income takes, it is all interest and for munis, generally all tax-free.
Consider a "vanilla" muni issued with a coupon paying market rate, so the bond is priced at par. If market rates go up, the price of the bond will drop. It drops so that the net return, coupon plus "appreciation" to maturity yields the market rate of interest.
Now, instead of that discount coming from the issuer, it's coming from the market. The buyer is still buying a bond with a fixed rate of interest (combination of coupon and "appreciation"), so all the income is treated as interest, not gain. But since that extra interest comes from the secondary market seller, not from the original municipality issuer, that extra interest is taxable.
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A few numbers may help here. For clarity, I'll work with simple interest and ignore the effects of compounding. Say the market rate on 5 year munis is 4%. A muni might be issued with a 2% coupon and a price of $90.
(2% coupon + 2% price increase/year = 4% yield, give or take.)
After a year, the price has gone up to $92 and the buyer has received 2% in coupon payments. A total of 4%. The adjusted basis of the bond is $92, accounting for the accretion at 2%/year. And the buyer declares 4% in tax-free interest. This goes on for another four
years until maturity. The adjusted cost basis is then $100, there is no gain upon redemption, and the buyer has declared 4% tax-free interest each year.
Suppose after a year the rate on the bond increases to 5%. That could be because market rates generally have increased, or because the particular bond had a
credit event such as a technical default. It doesn't matter.
The bond is now priced at $88, so that in the four remaining
years it pays
($100 - $88) + 4 x 2% coupon = $12 + $8 = $20, or 5%/year.
If the owner sells now, there will be capital loss of $4: $88 sale price - $92 adjusted basis.
The buyer of that bond is getting a bond with $8 remaining OID (adjusted basis is $92) and $4 of market discount. The seller, not the municipality, is paying that extra $4 of income. So, to maturity $8 of accretion is tax-free, $4 is taxable.
Most of these effects are the same whether held by an individual or by a mutual fund, which simply passes through the taxes. (Though as noted before, it can't pass through a capital loss, though it can carry it forward.)
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Take the same example, except instead of the bond yield rising to 5% it falls to 3%. As before, this could be the result of general market rate declines or because the bond issuer is recovering from a credit event. It doesn't matter.
The bond is now priced at $96, so that in the remaining four
years it pays
($100 - $96) + 4 x 2% coupon = $4 + $8 = $12, or 3%/year.
The adjusted cost basis after a year is still $92, but the buyer is paying $96. That $4 is called
acquisition premium. The buyer is still paying below par; nevertheless, there's a market premium, not a market discount. This is why I was interested in seeing a specific CUSIP. One isn't necessarily buying at a
market discount simply because a bond is priced below par.
In summary:
- Market discount, which is relative to the adjusted cost basis, is treated as taxable interest, generally upon sale. (Owner has option to declare annually.)
- OID discount is treated as tax-free interest, declared annually, and used to increase adjust cost basis (much as reinvested divs change the cost basis of your mutual fund).
- Market premium (price in excess of adjusted cost basis) for munis must be amortized; it reduces the annual amount of tax free interest declared and also reduces the adjusted cost basis.
- Sale of a bond may be above or below the adjusted cost basis, resulting in a capital gain or loss.
All the examples above use simple interest. The actual calculations are significantly more complex. I've also disregarded de minimis treatment of market discount.
