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Unamortized Bond Premium What it Means How it Works Example

Unamortized Bond Premium What it Means How it Works Example

Unamortized Bond Premium: Meaning, Function, Example

What Is Unamortized Bond Premium?

An unamortized bond premium is the difference between a bond’s face value and its sale price. If a bond is sold at a discount, such as 90 cents on the dollar, the issuer must still repay the full face value at par. This unpaid interest becomes a liability for the issuer.

Key Takeaways

  • An unamortized bond premium is the price difference between the sale of securities and the bonds’ face value at maturity.
  • This premium is a liability for issuers, as the interest expense has not yet been written off.
  • On financial statements, unamortized bond premium is recorded as a liability in the Unamortized Bond Premium Account.

Understanding Unamortized Bond Premium

Bond premium is the excess amount that a bond is priced above its face value. When interest rates decrease, bond prices increase. This happens when the market interest rate falls below the fixed coupon rate on existing bonds.

Holders of higher-interest paying bonds require a premium as compensation. The unamortized bond premium is the portion of the premium that the issuer has not yet written off as an interest expense.

For example, when interest rates were 5%, a bond issuer sold bonds with a fixed coupon of 5% paid annually. When interest rates dropped to 4%, new bond issuers offered bonds with the lower rate. Investors wanting higher-coupon bonds had to pay a premium to incentivize bondholders to sell. If a bond’s face value is $1,000 and it sells for $1,090, the unamortized bond premium is $90.

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This premium will be written off against future expenses. If the bond pays taxable interest, the bondholder can choose to use part of the premium to reduce taxable income.

Special Considerations

Investors in taxable premium bonds benefit from amortizing the premium. This reduces the amount of taxable income from the bond. The taxable bond’s cost basis is reduced by the amount of premium amortized each year.

If a bond pays tax-exempt interest, the bond investor must still amortize the premium. While this amount is not deductible for taxable income, the taxpayer must reduce their bond basis by the amortization for that year.

An unamortized bond premium is recorded as a liability on the bond issuer’s balance sheet in the Unamortized Bond Premium Account. This account shows the remaining premium amount yet to be amortized or charged off as interest expense during the bond’s lifespan.

Example: Calculating Unamortized Bond Premium

To calculate the annual amortized amount, multiply the bond price by the yield to maturity (YTM) and subtract it from the coupon rate:

  • Multiplying the bond price by the YTM yields $43.60.
  • Subtracting this from the coupon amount results in $6.40, the amortizable amount.
  • For tax purposes, a bondholder can reduce their interest income to $43.60.
  • After one year, the unamortized premium is $83.60.

For the second tax year, subtract the previous year’s amortized amount from the bond premium to calculate the cost basis. Calculate the premium amortization for the second year and subtract that from the remaining premium. Repeat this calculation for subsequent years until the bond matures. For example, the bond’s cost basis in the third year would be $1,076.96.

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