Definition
A bond premium is the amount the purchaser pays in buying a bond that exceeds the bond’s face or call value. If an investor purchases a bond for more than its nominal (face) value, the overpayment is known as a premium. This situation typically arises when the bond’s coupon rate (interest rate) is higher than the prevailing market interest rates.
Amortization of Bond Premium
Amortization of the bond premium is the process of gradually writing down this premium over the life of the bond. Amortizing the bond premium reduces the taxable interest income reported by the bondholder each year to reflect the bond’s yield to maturity (YTM), the true interest rate, as being lower than the stated coupon rate. This process is mandatory for taxable bonds but is not allowed for tax-exempt bonds.
Example
Taxable Bond
- Bond Details: USD 1,000 face value, 10-year maturity, 5% coupon rate.
- Purchase Price: USD 1,200 (reflects premium due to high coupon rate)
- The USD 200 premium can be amortized over 10 years, reducing annual interest income by USD 20.
Tax-Exempt Bond
- Bond Details: USD 1,000 face value, 20-year maturity, 4% coupon rate.
- Purchase Price: USD 1,100.
- The USD 100 premium cannot be amortized for tax reporting purposes.
Frequently Asked Questions
Q1: Why do investors pay a bond premium? A1: Investors pay a bond premium when the bond’s coupon rate is higher than the prevailing market interest rates, seeking higher regular interest income.
Q2: How does bond premium amortization affect taxable income? A2: Amortizing bond premium for taxable bonds reduces the bondholder’s taxable interest income, aligning it closer to the bond’s yield to maturity.
Q3: Can the premium on tax-exempt bonds be amortized? A3: No, the amortization of premiums on tax-exempt bonds is not allowed for tax purposes.
Q4: Is amortizing a bond premium elective? A4: Amortization of a premium on taxable bonds is elective, allowing future reduction in taxable interest income, but, once elected, it must be consistently applied.
Q5: What happens if a bond is sold before maturity? A5: If a bond is sold before maturity, any remaining unamortized premium adjusts the bond’s basis and affects the capital gain or loss calculation.
Related Terms
- Face Value: The nominal value of the bond as stated by the issuer.
- Coupon Rate: The interest rate the bond issuer pays to bondholders.
- Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures.
- Call Value: The price at which a bond can be redeemed by the issuer before its maturity date.
Online References
Suggested Books for Further Studies
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
- “The Bond Book” by Annette Thau
- “Investing in Bonds For Dummies” by Russell Wild
Fundamentals of Bond Premium: Finance Basics Quiz
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