Quick Answer
A premium paid at purchase must be amortized (mandatory, non-deductible) down to par; an original issue discount is accreted (tax-free) up to par. A discount bought later in the secondary market is a different animal: market discount, taxed as ordinary income, not tax-free like OID.
Now that you understand how municipal bonds are priced, let's look at what happens to the cost basis when you buy a bond above or below par. The tax treatment of premiums and discounts is one of the most tested areas in municipal bond math.
How Does Premium Amortization Work?
When a tax-exempt municipal bond is purchased at a premium (above par), the premium must be amortized. This is mandatory, not optional.
Think of it this way: You paid extra for a bond that will only pay back par at maturity. Each year, a portion of that "overpayment" is written off, gradually walking your cost basis down to what you will actually receive at the end.
Key rules:
- Amortization reduces the cost basis annually toward par over the remaining life of the bond
- The amortized premium is not deductible against income (unlike taxable bonds)
- At maturity, the adjusted cost basis equals par, so there is no capital loss at redemption
- Straight-line amortization (for Series 7): premium / years to maturity
Example: Premium Amortization
Buy a 5% municipal bond at 108 (10 years to maturity):
- Purchase price: $1,080
- Par value: $1,000
- Premium: $80
- Annual amortization: $80 / 10 = $8 per year
| Year | Adjusted Cost Basis |
|---|---|
| Purchase | $1,080 |
| After 1 year | $1,072 |
| After 5 years | $1,040 |
| At maturity (year 10) | $1,000 (no gain or loss) |
If sold before maturity, gain or loss is calculated against the amortized cost basis, not the original purchase price.
Exam Tip: Gotchas
- Premium amortization on tax-exempt munis is MANDATORY (not optional) and the amortized amount is NOT tax-deductible.
- If you sell a premium bond before maturity, use the amortized basis (not original cost) to calculate gain or loss.
How Does OID Accretion Work?
When a municipal bond is issued at an original issue discount (below par at issuance), the discount is accreted (added to basis) over the life of the bond.
Key rules:
- OID on a tax-exempt bond is treated as tax-free interest (not taxable income)
- Annual accretion (straight-line): OID / years to maturity
- At maturity, the adjusted cost basis equals par, so there is no capital gain at redemption
- If sold before maturity for more than the accreted value, the excess is a capital gain
Example: OID Accretion
Buy a new-issue municipal bond at 92 (20 years to maturity):
- Purchase price: $920
- Par value: $1,000
- OID: $80
- Annual accretion: $80 / 20 = $4 per year
| Year | Adjusted Cost Basis |
|---|---|
| Purchase | $920 |
| After 5 years | $940 |
| After 10 years | $960 |
| At maturity (year 20) | $1,000 (no gain) |
If sold at $960 after 5 years: $960 - $940 (accreted basis) = $20 capital gain
How Does Market Discount Differ from OID?
When a municipal bond is purchased in the secondary market at a discount (below par for bonds originally issued at par, or below the current accreted value for OID bonds), the discount is a market discount.
Critical distinction from OID:
| Feature | OID (Original Issue Discount) | Market Discount |
|---|---|---|
| When it occurs | At original issuance | Secondary market purchase |
| Tax treatment on munis | Tax-free (treated as tax-exempt interest) | Taxable as ordinary income |
| When recognized | Accreted annually (adjusts basis) | At sale or maturity (or annual election) |
- Market discount on municipal bonds is taxed as ordinary income when realized
- The investor may choose to accrete market discount annually (paying tax each year) or defer recognition until sale or maturity
Exam Tip: Gotchas
- OID accretion on a tax-exempt muni is TAX-FREE (treated as tax-exempt interest). Market discount on a muni purchased in the secondary market is TAXABLE as ordinary income.
- OID = original issuance = tax-free. Market discount = secondary market = taxable.
What Drives Bond Price Sensitivity?
Why does this matter? When interest rates change, not all bonds react equally. Two characteristics determine how much a bond's price moves: how long until maturity and how large the coupon is.
- Longer maturity = greater price volatility for a given change in interest rates (more duration)
- Lower coupon = greater price volatility for a given change in interest rates
- A zero-coupon bond has the highest price volatility of any bond with the same maturity
- As a bond approaches maturity, its price converges toward par (the "pull to par" effect)
Exam Tip: Gotchas
- Zero-coupon bonds have the highest price sensitivity to interest rate changes of any bond with the same maturity. No coupon payments means all value is in the final payment, so duration is maximized.
- Lower coupon = more volatility. A 2% bond moves more in price than a 6% bond when rates change by the same amount.
What Should You Check on Exam Day?
- Confirm whether a scenario describes a premium (amortize, mandatory, no deduction) or an original issue discount (accrete, tax-free).
- Distinguish OID (tax-free accretion) from market discount (taxable as ordinary income) purely by whether the discount arose at issuance or in a later secondary-market purchase.
- Use the amortized or accreted basis, not the original purchase price, when calculating gain or loss on an early sale.
- Identify which bond has the highest price sensitivity: longest maturity, lowest coupon, or zero coupon.