Amortizable Bond Premium

What it is

An amortizable bond premium is the amount paid for a bond above its face (par) value. For many taxable bonds, that premium can be amortized over the life of the bond to reduce the amount of interest income reported for tax purposes. The Internal Revenue Service requires the constant yield method be used to calculate the annual amortization.

Key points

• Premium = purchase price − face (par) value. Example: a $1,000 bond bought for $1,050 has a $50 premium.
• Amortizing the premium reduces the bondholder’s taxable interest income and lowers the bond’s cost basis each year.
• If the bond pays tax-exempt interest, the premium must be amortized but the amortized amount is not deductible; it only reduces the bond’s basis.
• The IRS-mandated method for amortization is the constant yield method (also called the constant-interest or actuarial method).

Why premiums arise

Bond prices and yields move inversely. When market interest rates fall below a bond’s coupon rate, the bond’s price rises above par and sells at a premium. As the bond approaches maturity, its market value converges to par; the premium is therefore amortized over time.

Tax and cost-basis effects

• For taxable bonds: electing to amortize reduces reported interest income each period by the amortized premium; the bond’s cost basis is reduced by that amount.
• For tax-exempt bonds: amortization is required; it reduces the bond’s basis but does not reduce taxable income because the interest is already tax-exempt.
• Keeping accurate amortization schedules is important for correct tax reporting and for calculating gain or loss when the bond is sold or matures.

Constant yield method — how it works

The constant yield method amortizes the premium based on the bond’s yield to maturity (YTM). The accrual (amortization) for an accrual period is calculated as:

Accrual = (Adjusted basis × periodic YTM) − coupon payment for the period

Where:
* Adjusted basis is the bond’s purchase price adjusted by prior accruals.
Periodic YTM = annual YTM ÷ number of accrual periods per year.
Coupon payment = (annual coupon rate ÷ periods per year) × face value.

Each period’s accrual is subtracted from the basis (a premium produces a negative accrual, reducing basis). Repeat for each period until the bond reaches par at maturity.

Example (semi‑annual coupon)

An investor buys a 5-year bond with:
* Face value = $10,000
Purchase price = $10,150 (premium = $150)
Coupon = 5% annually, paid semi‑annually → coupon per period = 0.05/2 × $10,000 = $250
* Yield to maturity (YTM) = 3.5% annually → periodic YTM = 3.5%/2 = 1.75%

Period 1:
Accrual1 = $10,150 × 1.75% − $250 = $177.63 − $250 = −$72.38
Adjusted basis after period 1 = $10,150 − $72.38 = $10,077.62

Period 2:
Accrual2 = $10,077.62 × 1.75% − $250 = $176.36 − $250 = −$73.64
Adjusted basis after period 2 = $10,077.62 − $73.64 = $10,003.98

Continue this process for the remaining periods (10 semi‑annual periods total). Negative accruals indicate the premium is being amortized and the basis is declining toward par.

Practical takeaways

• Amortizing a premium can reduce taxable interest income for taxable bonds and helps align cost basis with eventual redemption at par.
• The constant yield method is required by the IRS; use it consistently and keep records.
• For tax-exempt bonds, amortization affects basis but not taxable income.
• Consult a tax advisor or use tax software/tools to ensure correct calculations and reporting.

Sources

• IRS Publication 550 — Investment Income and Expenses (bond premium amortization)
• IRS Publication 1212 — Guide to Original Issue Discount (OID) Instruments: Constant Yield Method