Definition: The annual amount of money lost by the owner of a bond because he or she bought the bond for more than its face value and but will receive only the face value when the bond’s term is up (ie, matures).
Example: A bond has a face value of $1,000. It matures in one year. Ravjot buys the bond for $1010 ($10 more than face value) because the higher interest rate it pays compared to newer bonds makes paying extra worth it. The loss of the extra $10 paid for the bond represents amortization of the bond.
Investeach explains: A person would only overpay for a bond if the interest that the bond pays is higher than the interest rate on new bonds being sold for $1,000. Let’s say that Ravjot has two choices:
– Buy Bond A, which has one year left and a 6.25% stated (ie, coupon) interest rate, for $1,010, or
– Buy Bond B, which is a new one-year bond with a 5% stated (ie, coupon) interest rate, for $1,000
Bond A will pay the bondholder 6.25% of its $1,000 face value, or $62.50 in interest in its last year. Bond B will pay the bondholder 5% of its $1,000 face value, or $50.00 in interest during its one year life. By buying Bond A, Ravjot earns $62.50 minus the extra $10 he paid for the bond, or $52.50. This is more than the $50 he would have earned for the year owning Bond B. Getting back to our definition, the $10 lost upon receiving back only $1,000 for the bond Ravjot paid $1,010 for represents amortization that can be subtracted from the interest earned during the year.
Riddle me this:
1. Why would an investor pay more for a bond than its face value?
2. Against what can the amortization amount be offset when an investor computes her bond income?