Bond premiums

If you buy a bond that pays an interest rate over and above the market interest rate, implicit in your purchase price is something called the bond premium. The bond premium is just the market's way of adjusting the price of a bond that pays too high of an interest rate.

Bond premiums, unfortunately, present nightmarish difficulties for your record keeping.
Theoretically, what you should do is amortize the amount of the bond premium over the life of the bond. In effect, this premium allocation lets you chop up the amount of the premium and allocate it over the period that the bond pays its interest, thereby reducing the bond interest. For example, if you implicitly pay $100 of bond premium for a bond that will pay interest over ten years, it would make sense, roughly speaking, to reduce the amount of bond interest you actually record by $10 a year. The $10 amount equals 1/10th of the $100 bond premium. We say "roughly speaking" here because actually the calculations are more complicated than a simple straight line
allocation. You should use an effective interest rate to adjust the annual bond interest to an amount so that the interest rate stays equal to the bond's yield to maturity. But that discussion is really beyond the scope of this book.

Because of this complexity, we recommend that you simply ignore the bond premium. By ignoring the premium, you will overstate the interest you will earn over the years that you hold the bond, meaning that you will pay more in income taxes on the bond interest over those years. (At the end of the bond life, you will show a capital loss on the bond equal to the bond premium that you didn't record, but should have.) This strategy of ignoring the premium until the very end and then counting the bond
premium as a loss, or better yet, as an adjustment to the bond interest paid in the final year, makes your record keeping much, much simpler.

NOTE The IRS allows U.S. taxpayers to ignore the bond premium in annual bond in- terest calculations. This makes sense because by ignoring, or postponing, the bond premium, you overstate the interest you earn on the bond investment.

Bond Discounts

Bond discounts work in a fashion similar to bond premiums-except bond discounts occur when a bond pays an interest rate that is lower than the interest rate the mar- ket requires.

Theoretically, if you buy a bond at a discount, you are supposed to allocate the bond discount over the years that you hold the bond as additional bond interest income. For example, if you buy a bond for $900 but will receive $1,000 upon redemption, the $100 profit you make amounts to interest. This interest is essentially like that paid by a zero coupon bond.
When dealing with a bond discount, you do need to record accrued interest. The amount of the accrued interest equals the amount of the bond discount that is allocated to the year. Earlier in the chapter, we described how to record accrued in- terest on a zero coupon bond. The recording of accrued interest for a bond discount works in the same way. (The accrued interest for a bond discount is actually called amortization.)

Although the IRS requires U.S. taxpayers to amortize bond discounts, there is a loop- hole that might save you from the necessity of doing so. When a bond discount results in a very small change in the effective interest rate paid by a bond, you might be able to skip recording the amortization of the bond discount. If you have more questions about this, consult your tax advisor.