What Is an Amortizable Bond Premium?

What Is an Amortizable Bond Premium?

Let me explain what an amortizable bond premium is—it's a tax term for the extra amount you pay for a bond beyond its face value. Depending on the bond type, you can deduct this premium from your taxes by amortizing it proportionally over the bond's life.

Key Takeaways

As a tax concept, the amortizable bond premium is simply the premium you pay over the bond's face value. This premium forms part of your bond's cost basis, making it tax-deductible when amortized evenly across the bond's duration. You'll find amortizing the premium useful because it counters the bond's interest income, lowering your overall taxable income. Remember, the IRS insists on using the constant yield method for your annual amortizable bond premium calculations.

Understanding an Amortizable Bond Premium

You see a bond premium when the bond's price rises in the secondary market because market interest rates have fallen. If a bond sells at a premium to par, its market price exceeds the face value. The premium is the gap between the bond's current price or carrying value and its face value. For instance, if a bond with a $1,000 face value sells for $1,050, that's a $50 premium. As maturity nears, the bond's value decreases gradually until it hits par at maturity—this decrease is what we call amortization.

Cost Basis

For you as a bond investor, the premium you pay becomes part of the bond's cost basis, which matters for taxes. If the bond yields taxable interest, you can opt to amortize the premium, using portions of it to cut down the interest income you report for taxes. Investors in taxable premium bonds usually gain from this amortization, as it offsets the bond's interest income, reducing taxable income and any taxes owed. Each year, the taxable bond's cost basis drops by the amortized premium amount.

Now, if the bond offers tax-exempt interest, you must amortize the premium anyway. This amortized amount isn't deductible for taxable income, but you do reduce your bond basis by that yearly amortization. The IRS requires the constant yield method for amortizing any bond premium annually.

Amortizing Bond Premium With the Constant Yield Method

You use the constant yield method to figure out bond premium amortization for each accrual period. It works by multiplying your adjusted basis by the issuance yield and subtracting the coupon interest. The formula is: Accrual = Purchase Basis x (YTM / Accrual periods per year) - Coupon Interest.

Start by calculating the yield to maturity (YTM), the discount rate that matches the present value of all future bond payments to your basis in the bond. Take an example: suppose you buy a bond for $10,150 with a five-year maturity, $10,000 par value, 5% semi-annual coupon, and 3.5% YTM. I'll walk you through the amortization for the first and second periods.

The First Period

Since this bond pays semi-annually, each period is six months. We divide the yield and coupon by 2 for a six-month accrual. So, the yield becomes 3.5%/2 = 1.75%, and the coupon per period is 5%/2 x $10,000 = $250. For period 1: Accrual = ($10,150 x 1.75%) - $250 = $177.63 - $250 = -$72.38.

The Second Period

For the second period, adjust the basis to purchase price plus first-period accrual: $10,150 - $72.38 = $10,077.62. Then: Accrual = ($10,077.62 x 1.75%) - $250 = $176.36 - $250 = -$73.64.

Remaining Periods

For the other eight periods in this five-year semi-annual bond, apply the same method to calculate the amortizable premium. Essentially, a premium bond purchase leads to negative accrual, meaning the basis amortizes over time.