Small business owners often look to investments as a way to increase capital to grow their businesses. Bonds are one way to do this without taking on the substantial risks of the stock market. When you purchase bonds, you are essentially giving the government or a corporation a loan for a certain length of time and collecting interest payments as profit.
Understanding Amortized Bonds
As an investor, it is crucial to understand how amortized bonds work because the interest paid back counts as income for you. Amortized bonds are loans in which the borrower pays back both the principal and the interest throughout the life of the loan. By amortizing the bonds, you avoid paying taxes on the interest income all at once and instead spread it out over the life of the bond.
Calculating a Bond Premium
An amortizable bond premium is the amount owed that exceeds the actual value of the bond. For instance, you might pay $10,500 for a $10,000 bond. In this instance, $500 is the amortizable bond premium. This is considered the bond premium or trade premium because the bond cost more for you to purchase than it is actually worth.
Straight-Line Method of Amortization of Bond Premium Amounts
One way to calculate the amortization over the life of the bond is by using the straight-line method of amortization of bond premium amounts. This is the simplest way to amortize a bond, but it is not recognized by the IRS for tax purposes.
The first step in the straight-line method of amortization of bond premium income is to subtract the bond face value from the amount paid to calculate the premium. For example:
- $10,500 - $10,000 = $500
If there are 36 months left before the bond matures, then to find the amortized bond premium, you do the following calculations:
- $500 bond premium ÷ 36 months = $13.89 per month
- $13.89 per month x 12 months in a year = $166.68 per year
Constant-Yield Method of Amortization
The constant-yield method of amortization is the method currently prescribed by the IRS for tax returns, and it is more complicated to figure. If math is not your strong suit, consider using a bond premium amortization calculator or spreadsheet to automatically do the calculations for you. In order to use these tools, you will need to gather the following information:
- issuer name or CUSIP number
- bond amount
- par value
- settlement date
- issue date
- date of next coupon
- interest-payment frequency
- interest-payment type
- coupon rate of interest
- due date
- yield to maturity
- call price
- amortization type
- bond type
If you prefer to make your own premium amortization table, keep in mind that you will need to make new calculations for each accrual period. Let's say you pay $10,500 for a bond with a maturity value of $10,000 that matures in five years, a 5% coupon rate and a yield to maturity of 3.5%, with interest payments every six months. Here's how you would prepare to calculate amortization for the first accrual period:
- Divide your yield in half: 3.5%/2 = 1.75%
- Divide your coupon rate in half: 5%/2 = 2.5%
- Coupon payment per period: 2.5% x 10,000 = $250
Then, use these figures to help you with the following amortization calculation for period one:
- Period one = (10,500 x 1.75%) - $250
- Period one = $183.75 - $250
- Period one = -$66.25
To calculate the amortization for the second period, you will subtract $66.25 from $10,500 to arrive at $10,433.75 as your new starting number:
- Period two = ($10,433.75 x 1.75%) - $250
- Period two = $182.59 - $250
- Period two = -$67.41
Continue these calculations the same way for the remaining accrual periods until the bond comes to maturity.