Amortization is an accounting and tax tool used to describe how a bond purchased at par must inevitably decline in value as it approaches an effective call date or maturity. For large amounts of bonds, the cumulative effect of amortization (similar to depreciation for real assets like machinery) is substantial. The effect of amortization is important for tax reporting.
Amortize a bond that costs 109. The bond is callable in five years at 103 and matures in 10 years at par. Find the annual amortization for accounting and tax purposes. Price the bond using the dollar price and determine the higher yield to call or maturity. The higher yield tells you whether call or price is the active amortization.
Subtract the call price from the bond cost. The premium is six points (109 minus 103). Divide six by the number of years to the call (6/5). The annual amortization decay is 1.2. On a $10,000 par amount, bond the premium would be $600. The amortization would be $120 per year. Next year's cost basis is 107.8.
Subtract the maturity price (par or 100) from the bond cost. The premium is nine points (109 minus 100). Divide nine by the number of years to the call (9/10). The annual amortization decay is .9. On a $10,000 par amount bond, the premium would be $900. The amortization would be $90 per year. Next year's cost basis is 108.1.
Use the bond calculator (see Resources) and compute the nine intervening years of bond values, assuming the same yield to maturity. The net effect is that the amortization will be less in the beginning years but increases the closer the bond is to the effective call or maturity date. Most investors use the simple method described earlier.
Use amortization to compute income tax deductions. An amortization of $500 per year is a $500 tax deduction. Amortization is deductible for income tax purposes as it approximates capital loss (accretion of a discount is a taxable event) during the life of the bond. You must use amortization if you sell a bond. It will lower your cost basis in the bond.
Understand that amortization is an accounting device. Amortizing a bond says nothing about its market value. If you buy a premium bond and interest rates fall, the bond will go up in price while your cost basis declines.
Do not amortize a bond from current cost. Use the original cost at time of purchase.
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