Amortizable bond premium refers to the excess of the purchase price of a bond over its face value. When investors buy bonds at a premium (a price higher than the face value), the premium is generally amortized over the life of the bond. Amortization is the process of spreading the bond premium over the bond’s term, resulting in a reduction of the premium over time.
Here are key points about amortizable bond premium:
1. **Purchase Price and Face Value:**
– The purchase price is the amount investors pay to acquire a bond in the secondary market. The face value, also known as the par value, is the principal amount that will be repaid to the bondholder at maturity.
2. **Amortization Process:**
– Amortizable bond premium is amortized using a method that reflects the economic reality of the bond’s interest payments. The most common method is the constant yield method.
3. **Constant Yield Method:**
– The constant yield method calculates the annual amortization of the premium by determining a constant yield (interest rate) that, when applied to the remaining carrying value of the bond, produces an amount equal to the total future cash flows (interest and principal payments). This results in a level amortization amount over the bond’s life.
4. **Accounting Treatment:**
– The amortization of the bond premium is recorded as an adjustment to interest income on the income statement. The carrying value of the bond on the balance sheet is reduced by the amortization amount each period.
5. **Tax Implications:**
– For tax purposes, the amortizable bond premium can be used to offset the taxable interest income generated by the bond. Investors may deduct the amortization amount from the interest income, resulting in a lower taxable income.
6. **Reduction of Premium:**
– Over time, as the bond approaches maturity, the amortizable bond premium decreases until it is fully amortized and the carrying value of the bond matches its face value.
7. **Zero Coupon Bonds:**
– Zero coupon bonds, which do not make periodic interest payments, may also have an amortizable bond premium. In this case, the premium is amortized over the life of the bond, and the amortization is considered an imputed interest expense.
Understanding the amortizable bond premium is important for investors who hold bonds with premiums, as it affects both the accounting treatment of the investment and the taxable income associated with it. Investors should be aware of the specific terms of their bonds and consult with financial professionals for accurate and current information.