Why Amortize the Premium or Discount on Bonds Each Period?

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The amortization of bonds is the process of reducing the cost basis of bonds each period in order to reflect the economic reality that as bonds approach maturity, they must be redeemed at par, or 100. The reality is that amortization is easy to prepare and necessary for tax reporting. Amortization has different tax implications for different kinds of bonds. Amortization is normally done on a yearly basis.

Amortization Is Required for Tax Purposes

  • Amortization requires bondholders of premium bonds to reduce the cost basis of their holdings every tax reporting period. Usually, this coincides with the tax reporting period or every tax year. Holders of discount bonds employ a similar strategy called accretion, where the cost basis of bonds is increased toward par, or 100, as each year the bond moves toward maturity.

Tax Effects of Amortization

  • In taxable accounts amortization of a premium does not result in a capital loss for the customer, according to the Internal Revenue Service. With discount bonds, except for an original issue discount (OID) bond, such as a United States savings bond, the cost basis rises and is a taxable capital gain. Investors seeking to avoid the inconvenience of reporting these changes for each individual bond should consider only the purchase of bonds sold at par or a bond fund.

Further Tax Effects

  • Bonds vary in price every trading day. Amortization is based on the reality that bonds must be redeemed at par at maturity. However, bond traders must use the new amortized cost when a bond is traded before maturity. Regardless of the original cost, a premium or discount bond that sells above its amortized cost is subject to tax. Similarly, bonds sold below amortized cost incur losses. For this reason tax swapping, in order to avoid capital gains on bonds, is an important strategic concept. Tax swapping involves trading bonds with losses for similar bonds in order to recognize the tax loss for income tax purposes.

Amortization Rules Acknowledge Par Payment at Maturity

  • Premium bonds reflect the fact that interest rates have dropped since the bond was issued. Discount bonds are issued in lower interest rate environments. Premium and discount bonds tend to par prices if interest rates are unchanged until maturity. Bond prices are similar because near maturity the bond prices will be converging. Most bonds have early redemption features, or calls, for a specific date and price. Premium bonds first amortize to the call feature. Any remaining amortization is spread to maturity. Discount bonds accrete to maturity only.

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