What Is the Premium on an Amortizable Bond?
The amount paid for an over and above its face value is the amortizable bond premium in tax terminology. Depending on the bond’s kind, the premium may be deducted from income and prorated throughout the bond’s lifetime.
A Guide to Amortizable Bond Premiums
A bond premium happens when the bond’s secondary market price rises due to a decline in interest rates. A bond with a market price over its face value was sold at a premium to par.
The bond premium is determined by dividing its face value by its current price (carrying value). For instance, a bond with a $1,000 face value that sells for $1,050 has a $50 premium. As the bond’s maturity date draws nearer, its value gradually decreases until it equals its par value. Amortization describes the steady decline of the bond’s value.
For a bond investor, a portion of the bond’s cost basis, which is significant for tax purposes, is represented by the premium paid for the bond. The bondholder may decide to amortize the premium if the bond pays taxable interest, which entails using a portion of the premium to lower the interest income that must be included in taxes.
Generally, amortizing the premium is advantageous for investors in taxable premium bonds since the proceeds can be used to reduce interest payments. As a result, the bond will earn less taxable income, which will lower the amount of income tax owed on it as well. The amount of premium amortized each year is deducted from the cost basis of the taxable bond. The bond investor must amortize the bond premium if the bond pays tax-exempt interest. The taxpayer must subtract the annual amortization from their basis in the bond even if this amortized amount is not deductible for calculating taxable income. According to the IRS, the constant yield approach must be applied annually to amortize bond premiums.
Paying Off Bond Premium: The Constant Yield Approach
The amortization of the bond premium is calculated for each accrual period using the constant yield approach. A bond premium is amortized by dividing the adjusted basis by the yield at issue and then taking away the coupon interest. Alternatively, use the formula:
Accrual is Purchase Basis times the number of annual accrual periods minus the coupon interest.
Finding the yield to maturity (YTM), the discount rate that converts the present value of all future bond payments to the bond’s base is the first step in computing the premium amortization.
Consider an investor who paid $10,150 for a bond as an illustration. The bond has a par value of $10,000 and a five-year maturity date. It has a yield to maturity of 3.5% and pays a 5% coupon rate semi-annually. The amortization for the first and second periods should be calculated.
The Initial Phase
Due to the semi-annual nature of this bond’s payments, the first period corresponds to the first six months, after which the investor receives the first coupon payment; the second period is the next six months, and so on. The yield and coupon rate will be split by two because we’re considering a six-month accrual period.
Using our example as a guide, the yield applied to the bond premium amortization is 3.5%/2 = 1.75%, and the periodic coupon payment is 5% / 2 x $10,000 = $250. Following is the amortization during period 1:
Accrual period 1 = ($10,150 multiplied by 1.75%) – $250
Accrual period 1 equals $177.63 – $250
Accrual period 1 = -72.38 dollars
A second time frame
The purchase price plus the accrual from the first period, or $10,150 – $72.38 = $10,077.62, is the foundation for the bond in the second period.
Accrualperiod2 = ($10,077.62 multiplied by 1.75%) – $250
Accrualperiod2 = -$250 to $176.36
Accrualperiod2 = -73.64 dollars.
Use the formula shown above to get the amortizable bond premium for the remaining eight periods (10 accrual or payment periods for a semi-annual bond with a maturity of five years).
A bond bought at a premium has a negative accrual by nature; in other words, the basis depreciates.
- The extra price (the premium) paid for a bond over and above its face value is referred to as the amortizable bond premium, which is a tax phrase.
- Tax deductions may be available for premiums paid for bonds because they are part of the bond’s cost basis and are amortized throughout the bond’s life.
- Amortizing the premium may be beneficial since the tax deduction can offset any interest income the bond may provide, lowering the investor’s overall taxable income.
- The annual amortizable bond premium must be calculated using the constant yield technique, per the IRS.