Original Issue Discount (OID) of Municipal
Bond
Constant Yield To Maturity
In order to avoid this result, the Internal
Revenue Code (the "Code") provides that the holder's basis will
increase over time based on a "constant yield to maturity"
(CYM) method. Because this CYM method is also utilized for
other purposes related to taxexempt bonds, including the
treatment of premium and "market discount," we will calculate
the CYM on the above bond to demonstrate how the holder's basis
is increased.
In order to determine the constant yield to
maturity on a municipal bond, it is necessary to determine
a constant discount rate that must be applied to each and every
payment on the municipal bond (principal and interest) in order
to produce an aggregate value (as of the issue date) that is
equal to the issue price of the municipal bond. Using the
above example (a bond that will pay $125 semiannually for 10
years, with a final principal payment of $5,000 at the end of
such ten year period), the discount rate that must be applied
to each of those payments to produce a value of $4,628 is
6.00%, compounded semiannually.
Thus, even though the stated interest rate
is 5%, the municipal bond actually produces a yield
to the municipal bond holder of 6% due to its being issued at a
discount. This 6% CYM will enter into the accretion of the
holder's basis and such basis will increase each year by an
amount equal to the excess of

the accreted issue price at the beginning of each
semiannual period multiplied by the 3% yield (6%
annual yield divided by 2 to reflect interest
payments), over

the amount of interest actually paid on the
municipal bond during such period.
For instance, assume the municipal bond
holder purchased the municipal bond upon issuance on July 1,
2003. The holder's basis six months later on January 1, 2004
would be equal to the opening basis of $4,628 plus ($4,628 x 3%
or $138.84) minus ($125 of interest), which will produce a
basis of $4,641.84 as of January 1, 2004. Because this
calculation is only necessary to determine the municipal bond
holder's basis, it need not be done by the municipal bond
holder until sale or other disposition of the
municipal bond and, if the municipal bond holder holds the
municipal bond until maturity, it need never be done. The basis
of a municipal bond purchased at issuance and held to maturity
will equal the principal amount of the municipal bond at
maturity.
In the case of a taxable bond, if the OID is
less than onefourth of one percent (1/4%) of the principal
amount of the bond multiplied by the number of full years until
the bond's maturity, the OID is treated as de minimis and is
ignored. This rule does not apply in the case of a taxexempt
bond in order to ensure that the full amount of OID is treated
as taxexempt interest to the holder and that the holder does
not have an "artificial" gain on the sale of the bond.
