What it means
Bonds trade above face value when their coupon is higher than the yield the market currently demands. An investor who pays $106,000 for a bond that will repay only $100,000 at maturity has effectively prepaid $6,000 to receive above-market coupons, and that prepayment is the premium.
The accounting and tax treatment matters because raw coupon income is misleading. The cash coupon overstates the true economic return, since part of every payment is really the investor's own capital coming back, and writing off the premium corrects the picture.
Mechanically the premium is spread across the years to maturity and each year's slice is deducted from the interest income reported. The bond's carrying value falls in step, reaching exactly face value on the maturity date so no gain or loss arises then.
Two methods are used. Straight-line simply divides the premium by the number of years remaining, while the constant yield or effective interest method allocates it so that the reported return stays a fixed percentage of the carrying value, which is the method most accounting standards require.
There is an important tax wrinkle for individuals. On taxable bonds the write-off is usually optional but, once elected, applies to all similar bonds held and to future years, whereas on tax-exempt bonds the premium must be written off and gives no deduction because the interest was not taxed anyway.
In practice
Real-world examples.
Example
A charitable foundation buys $2 million of face value corporate bonds at 104 with eight years to run. It writes off $10,000 of premium a year, reducing reported investment income and keeping the trustees' distribution policy anchored to true economic yield.
Example
An insurance company holds a large book of premium-priced government bonds. Its accounting team uses the effective interest method so the reported yield on each holding stays constant, which keeps the investment return disclosure consistent across the portfolio.
Example
A retired investor buys municipal bonds at a premium. Her adviser explains that the premium must be written off but produces no tax deduction, because the coupon income was already exempt, so the only effect is on the cost basis.
Formula
Calculation
Annual straight-line premium write-off = (purchase price - face value) / years to maturity
An investor buys a corporate bond with a face value of $100,000 for $106,000 with exactly six years left to maturity, and the bond pays a 5% coupon. The premium is $106,000 - $100,000 = $6,000, so the annual write-off is $6,000 / 6 = $1,000. The cash coupon each year is $100,000 x 0.05 = $5,000, so taxable interest income becomes $5,000 - $1,000 = $4,000. The carrying value falls from $106,000 to $106,000 - $1,000 = $105,000 after the first year and continues down by $1,000 a year until it reaches $100,000 at maturity.Case study
Seen in the real world.
This case is illustrative and entirely fictional. Ravensworth Endowment, an invented university fund, spent several years reporting investment income that its finance committee could never reconcile with actual portfolio growth. The endowment held roughly $18 million of bonds bought at prices well above face value during a period of falling rates.
An external review found the fund was reporting gross coupon income of about $940,000 a year while ignoring the premium entirely. Once the premium was written off correctly, reported income dropped to roughly $760,000, and the phantom $180,000 turned out to be the endowment's own capital circulating back to it.
The committee had been setting its annual spending rate against the inflated figure and was quietly eroding capital. After the correction the spending policy was rebased, and the fund's investment report started showing both cash coupon and premium-adjusted income side by side.
Watch out
Common mistakes.
- Treating the whole coupon as income. Part of a premium bond's coupon is a return of the price paid above face value, not genuine earnings.
- Expecting a capital loss at maturity. If the premium has been written off properly the carrying value already equals face value, so redemption produces no loss at all.
- Applying the straight-line method where the effective interest method is required. Accounting standards generally require constant yield, and straight-line is only acceptable where the difference is immaterial.
Questions
People also ask.
Why would anyone pay more than face value for a bond?
Because its coupon is above the current market yield, so the extra price buys a stream of above-market payments.
Is the write-off compulsory?
For financial reporting, yes; for individual tax on taxable bonds it is usually an election, but once made it binds future years and similar holdings.
What happens if the bond is sold early?
The remaining unwritten premium adjusts the cost basis used to work out the gain or loss on sale.
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