Amortizable Bond Premium
Big term, simple concept. When a bond has a higher coupon than current interest rates, you pay a premium for it (i.e., more money). That premium can be amortized for tax purposes, meaning that it is split up over a period of years.
Put simply, you then take a portion of that premium each year against your cost basis (what you actually paid for it). Like...you paid $1,050 for a $1,000 par value bond with a coupon of 6% coming due in 5 years. You'd get 60 bucks a year for those 5 years...but you'd amortize away for tax purposes the 10 bucks you lost each year for 5 years as the premium value of the bond declined on its way to par.
That is, you'd pay taxes on 50 bucks (ordinary income), not on the $60 in cash you made as the amortization of the decline in value from premium to par functions essentially as a tax buffer.
Related or Semi-related Video
Finance: What is Par Value?113 Views
Finance a la shmoop what is par value okay mercifully we'll dispense [Man taking a swing with a golf club]
with the golf jokes but with one exception par in golf and it relates
here is the right number i.e the one you're shooting for the one you're
supposed to hit that is a par for golf hole is designed so that you hit your [A golf ball landing on the fairway]
drive then you hit your approach shot which is meant to land on the green and
then your quote supposed to unquote to putt for a total of four strokes at par [Man struggling to put the ball in the golfer hall]
4 right and it may or may not include saying close enough and picking up your
ball five feet away from the hole while calling it a gimme so yeah that's par
four strokes on a par 4 well in finance par value generally relates to the [Definition of par value relating to pricing of bonds written on chalkboard]
pricing of bonds and you'll see where we're going here with the right number
in quotes for a bond a corporation needs to borrow money to say build a new nose [Elephant using a noseclipper and chasing a man]
clipper factory well that new factory will allow the corporations
export Clippers to China and allow its products to be more high-tech yeah these
things are now the equivalent of a Brazilian wax for your nostrils anyway [Man giving a Brazilian wax to another mans nostrils]
the company along with its bankers believes that it should have to pay
about six percent interest on the loans it's taking out so it markets its bonds
as six percenters and in the process a more positive story is told to Wall [Men discussing the nose clipper industry bonds on Wall Street]
Street about the future of nose clipping technology as pioneered by shnozholes
Inc the perceived risk in the bond so sound and there's a lot of demand by [People looking up at Shnozholes, Inc building]
them the standard unit in which a bond is generally sold is a thousand dollars
that's a thousand dollars for each unit of a bond got it so on one unit of a
typical bond that thousand dollars interest is paid twice a year ie in this
case the company would be paying thirty bucks twice a year to rent each unit of [Company paying a bank $30 twice]
it's thousand dollar loan so the company issues the bonds and all of a sudden
they trade up on strong demand from Wall Street to eleven hundred dollars per
unit well a new buyer of the bond would be getting less than six percent [A new person buying bonds from the company]
interest when they bought that bond for 1,100 bucks because even though they
still get 30 bucks twice a year in bond rent money instead of paying a grand for
that 60 bucks a year they had to pay 1100 dollars for it in fact at 11 hundred [Buyers trading $1000 for $1,000]
dollars and still getting 60 bucks a year the interest rate has fallen to
about 5.45 percent ie less than six the quote right unquote value of that bond
or its par values yeah we went there, was a thousand bucks that's where it was
priced when it was offered and it's that thousand dollars from which the interest [Bank with a thumbs up beside the par value price]
payments are pegged how do we know what par value is well you can guess.. little
birdie told us [golfball striking a little bird perched on a tree]
Up Next
What is amortization? Amortization tracks the decline in value of a contract or service, usually paid for in advance. You received $10,000 in advan...
What is Bond Amortization? Bond amortization is simply the spreading out of the cost of the bond over time. Bonds have amortization schedules and t...
What is Coupon Stripping? Coupon stripping is the process of taking a coupon bearing bond and separating the coupons into individual zero coupon se...