Understanding Amortizable Bond Premium: A Guide to Smart Investment
The amortizable bond premium is an essential tax term that refers to the excess price paid for a bond, which is above its face value. This premium can often be tax-deductible and can be amortized over the bond’s life on a pro-rata basis. Here’s everything you need to know.
Key Insights
- The amortizable bond premium pertains to the excess price paid for a bond over its face value.
- This premium is part of the bond’s cost basis and can be spread out (amortized) over the bond’s lifespan.
- Amortizing the premium can offset interest income, thus decreasing overall taxable income.
- The IRS mandates the use of the constant yield method to calculate the amortizable bond premium annually.
What is an Amortizable Bond Premium?
A bond premium occurs when a bond’s market price exceeds its face value, often due to declining market interest rates. For example, if a bond with a face value of $1,000 is sold for $1,050, the premium is $50. Over time, as the bond nears maturity, its value decreases, and this gradual reduction is known as amortization.
Understanding the Cost Basis
For bond investors, the premium paid counts towards the bond’s cost basis, which holds significance for tax purposes. If a bond pays taxable interest, the bondholder can elect to amortize the premium, thereby lowering the amount of interest income that contributes to tax obligations.
Those with taxable premium bonds benefit from amortization since it offsets the bond’s interest income, consequently reducing taxable income and the associated taxes. Meanwhile, tax-exempt interest bonds require mandatory amortization of the bond premium. Although not deductible for tax purposes, the premium amortized decreases the bond’s basis each year.
Applying the Constant Yield Method for Amortizing Bond Premium
The constant yield method determines the amortization for each accrual period, multiplying the adjusted basis by the yield at issuance and then subtracting the coupon interest. Here’s the formula:
1Accrual = Purchase Basis x (YTM / Accrual periods per year) - Coupon Interest
The first step involves determining the bond’s Yield to Maturity (YTM), which is the discount rate making the present value of all remaining payments equal to the bond’s basis.
Consider an example of an investor who purchased a bond for $10,150 with a par value of $10,000, a five-year maturity date, a 5% semi-annual coupon rate, and a YTM of 3.5%. Here’s how to calculate the premium amortization:
The First Period
Assuming six-month payments, the yield and coupon rate are halved. Therefore, with 3.5% YTM divided by 2, the resulting yield is 1.75%, and the coupon payment is 5% ÷ 2 x $10,000 = $250.
1Accrual_period1_ = ($10,150 x 1.75%) - $250
2Accrual_period1_ = $177.63 - $250
3Accrual_period1_ = -$72.38
The Second Period
The bond’s basis for the next period is the initial purchase price minus the first-period accrual: $10,150 - $72.38 = $10,077.62.
1Accrual_period2_ = ($10,077.62 x 1.75%) - $250
2Accrual_period2_ = $176.36 - $250
3Accrual_period2_ = -$73.64
Use the same process for the remaining periods to calculate further amortizations.
Investors recognize that a bond bought at a premium inevitably encounters a reduced basis through negative accrual throughout its life. By understanding and harnessing the amortization of bond premiums, investors can smartly navigate their tax obligations and optimize their bond investments.
Related Terms: Cost Basis, Yield to Maturity, Coupon Interest.
References
- Internal Revenue Service. “Publication 550 (2020), Investment Income and Expenses: Bond Premium Amortization”.
- Internal Revenue Service. “Publication 1212 (01/2021), Guide to Original Issue Discount (OID) Instruments: Constant Yield Method”.
