What are the downsides, if any, of purchasing bonds on the secondary market instead of the primary market?

Question

Let's ignore the transaction fees from my broker, which tend to be higher for the secondary market. Are there any other downsides of purchasing bonds on the secondary market instead of the primary market? If that depends on the location, my main interest is the US.

Answer 1

One downside of purchasing municipal bonds (aka munis) on the secondary market instead of the primary market, as RonJohn mentioned in the comment section: municipal bonds on the secondary market may be discounted, and this discount is taxed.

Schwab has two good articles authored by Cooper Howard on it:

• Think Twice Before Buying a Muni Below Par
• Beware Taxes on Discounted Munis

Key takeaways from these two articles:

Discount definition:

Municipal bonds, or munis, are usually issued with a $1,000 par value, which is the amount you can expect to receive when the bond matures. However, after the initial issuance date, a muni’s value can rise and fall in the secondary market. Events such as rising interest rates or deteriorating credit quality can cause the value of the bond to fall below $1,000. When that happens, the bond is trading at a discount.

Tax treatment of muni discount:

Let's say you want to buy a $10,000 muni currently trading at $9,750—a $250 discount. When the bond matures in five years, barring default, you would receive the full par value of $10,000, meaning you would earn $250 on the bond plus the coupon income. What many investors may not realize is that they could owe taxes on that $250 discount.

Discounts are taxed using the de minimis rule, which uses the size of the discount to determine whether it will be taxed as capital gains¹ or ordinary income:

• A discount of less than 0.25% for each full year from the time of purchase to maturity is taxed as a capital gain.

• A discount of 0.25% or more for each full year from the time of purchase to maturity is taxed as ordinary income.

Returning to our example, you'd multiply the par value by the percentage threshold of 0.25% and the number of full years to maturity ($10,000 x 0.25% x 5), which gives you a dollar threshold of $125.

Special case 1:

Consider an original-issue-discount muni: Occasionally, a municipality will issue bonds at a discounted price, known as an original issue discount (OID). For such bonds, the OID is treated as part of the bonds' interest income and is usually exempt from capital gains and ordinary income taxes. (An OID bond trading in the secondary market, on the other hand, is subject to all the rules of a regular bond.)

Special case 2:

The purchase date matters: If you acquired a discount muni before April 1993, you’ll have to pay capital gains tax only.

Some brokers warn their clients about muni discount taxes, e.g. Schwab: