Since a bond bought at a discount generates a capital gains tax liability at maturity, does it generate a capital loss deduction at maturity if bought above par?
-- Kenneth Sarno
That depends on whether the bond is taxable or tax-exempt.
Before we get into that, let's review some terminology for readers less well-versed in it.
Bonds have a face value, typically some multiple of $1000, which is the amount you get when the bond matures.
Bonds are quoted as a percentage of face value. A bond with a face value of $1000 whose price is 98 costs $980, plus any
due to the seller. That means if you buy a bond between the dates on which it makes coupon payments, you have to give the seller the portion of the next coupon payment he is due, based on how many days into the payment period he owned the bond.
Most new bond issues are sold at par, meaning at a price of 100.
Now, at a price of 100, a bond's yield -- the essential measure of a bond's value -- is equal to its coupon rate. Bonds pay interest on their face value at a fixed rate, their coupon rate. A bond with a 6% coupon and a face value of $1000 pays $60 a year. If that bond is purchased at par, it is bought at a yield of 6%.
But bonds are routinely bought and sold at prices above and below par in the bond market. The price an investor is willing to pay for a bond is a function of interest rates. If new bonds of a certain type are being issued at par with 7% coupons, at a yield of 7%, then an old bond of the same type with a 6% coupon has less market value. An investor would buy it only at a price below par -- at a discount. The discount compensates the investor for forgoing the extra coupon income he could earn by buying a new issue. By buying at a discount, the investor can get the same yield he could get by buying a new issue. The discount becomes a component of the yield. This is why a bond's yield goes up when its price goes down.
Similarly, if new bonds of a certain type are being issued at par with 5% coupons, an old bond of the same type with a 6% coupon has more market value. An investor would be willing to buy it at a price above par -- at a premium.