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The 5 year interest rates in the last 2 years have gone up from 1% to 2.8%. So, in secondary market there are US government bonds with 1.5% and 2.75% face coupons.

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What I am trying to understand is - if it is no-brainer to buy bond with lower face coupon if I plan to hold until maturity, because it has larger disocunt that qualifies as capital gains?

Here is how I arrived to that conclusion:

  1. Since both bonds today have YTW equal to YTM and are 2.809% and 2.807% respectively, then aggregate Pre-Tax income for both bonds will almost be the same, right?
  2. However, the discount for both bonds is different. Hence, for the bond with lowe face cupon a larger portion of income will qualify as pre-tax income instead of ordinary income, right?
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(For US tax) If you buy a bond over 1 year in the market at a non-minimal discount, that 'gain' is taxed as interest (at nonpreferred rates) either ratably over its (remaining) lifetime or at disposition, your choice; see publication 550 at Market Discount Bonds.

If it is issued at a discount you don't even have a choice, it must be taxed as interest over the lifetime (even though you don't actually receive the difference of face and purchase until maturity or sale); this is called Original Issue Discount (OID) and covered earlier in the same publication.

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  • So, there is not way to qualify for [long-term] capital gain? In that case, is there ever a reason to pay attention to face cupon rate?
    – user4910112
    May 2, 2018 at 18:16
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    Sell it for profit before maturity. Your capital gain will be taxable.
    – Beanluc
    May 2, 2018 at 22:16
  • @HansSolo: you might care about actually receiving (all or more of) the interest periodically rather than waiting. Otherwise not.
    – dave_thompson_085
    May 4, 2018 at 7:25

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