The Amortization of Bond Premiums

In economics and finance, amortization refers to the allocation of a total current transaction value to another related account in a series of subdivided amounts over a number of periods. A common amortization example would be the allocation of the total value of a long-term asset to the expense account each year over the life of the asset so that the purchase cost of the asset is appropriately charged over time. In the case of bond premium amortization, the total amount of bond premium is allocated over the life of the bond to the interest account as part of each periodic interest payment.

Bond Premium

A bond premium is the amount in addition to the bond face value that bond investors have to pay the bond issuer or its current holder. A bond premium exists when the prevalent market interest rate as required by investors for buying the bond is lower than the stated interest rate on the bond. If purchased at the face value, the bond will be paying more in stated interest to investors than what the market requires. The additional premium reduces a bond’s stated interest payments to equal to the amount of the market interest.

Bond Interest

The stated bond interest payment by the bond issuer remain fixed over the life of the bond, while the market interest required by bond investors may be lower at the time of a bond purchase. The bond premium that bond investors pay in exchange for receiving the higher stated interest payment must be allocated to each interest-payment period as a subtraction from the stated interest to arrive at the market interest, which is the effective interest for investors. Such a process is referred to as the amortization of bond premiums.

Straight-Line Method

There are two ways to amortize bond premiums: straight-line method and effective interest method. While the straight-line method is simpler and may be appropriate if the amount of premium is relatively small, the effective interest method is more precise in deciding the actual market interest for each payment period. To use the straight-line method, divide the total amount of bond premium by the total number of interest-payment periods. Then, in each payment period, subtract the amortized amount from the amount of the stated interest payment to arrive at the interest payment that is symbolic for the market interest.

Effective-Interest Method

The effective-interest method allocates part of the total bond premium in the amount that would reduce a bond’s stated interest to the effective market interest. First, calculate the effective market interest by applying the market interest rate to the total bond carrying value, including the bond premium, at the beginning of a period. Next, compare the difference between the resulting market interest and stated interest to find the amount of amortization for the period. Meanwhile, the beginning bond carrying value is reduced by the amount of amortization to arrive at the end-period bond carrying value, which is also the beginning bond carrying value for the next period. When total bond premium is fully amortized by the maturity date, the initial bond carrying value has been gradually reduced to the face value of the bond.