How Do You Spell AMORTIZATION OF BOND PREMIUM?

Amortization of bond premium refers to the process of gradually reducing or accounting for the excess amount paid by an investor for a bond's purchase price. When a bond is sold at a price higher than its face value, it is said to be sold at a premium. This difference between the purchase price and the face value is known as the bond premium.

To account for this premium amount, investors use the amortization process to gradually decrease the premium over the bond's term, typically through regular deductions from interest income. The bond premium is amortized using the effective interest method, which allocates the premium as an adjustment to interest income over the bond's life.

The amortization of bond premium serves as a return adjustment mechanism for investors, ensuring that the premium amount is gradually absorbed and reflected in the bond's effective yield. Amortizing the premium eliminates the distortion caused by the initial premium payment, which would otherwise result in a higher recorded yield until maturity.

This accounting practice is required by generally accepted accounting principles (GAAP) and is used by both individual and institutional investors who invest in bonds. The amortization process is necessary to align the bond's stated coupon rate with the yield to maturity and to accurately reflect the economic reality of the bond's purchase price relative to its face value.