Bond premium amortization example?


E

Eric

I think I understand about adjusting the basis of a bond
each year for the premium paid for the bond, but what I'm
puzzled by is the exact calculation for the IRS's Constant
Yield Method. Here's a quote from Pub 550 on how to
determine the yield:

Step 1: determine your yield. Your yield is the discount
rate that, when used in figuring the present value of all
remaining payments to be made on the bond (including
payments of quali- fied stated interest), produces an amount
equal to your basis in the bond. Figure the yield as of the
date you got the bond. It must be constant over the term of
the bond and must be figured to at least two decimal places
when expressed as a percentage.

Could anybody help with an example? Once I know the yield,
I think I can make the basis-adjustment calculations.

BTW, my bond was called early, so that's why I need to
compute an accurate basis.

Thanks, Eric
 
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R

Rich Carreiro

Eric said:
I think I understand about adjusting the basis of a bond
each year for the premium paid for the bond, but what I'm
puzzled by is the exact calculation for the IRS's Constant
Yield Method. Here's a quote from Pub 550 on how to
determine the yield:

Step 1: determine your yield. Your yield is the discount
rate that, when used in figuring the present value of all
remaining payments to be made on the bond (including
payments of quali- fied stated interest), produces an amount
equal to your basis in the bond. Figure the yield as of the
date you got the bond. It must be constant over the term of
the bond and must be figured to at least two decimal places
when expressed as a percentage.
Yay, Congress. On the other hand, I can't really blame
them, since that's an economically correct thing to do.

In English, they are asking you to compute the
yield-to-maturity of your bond, given the exact price you
paid for it. So if you can find some physical or on-line
calculator that can do that YTM calculation, their answer is
the yield you're looking for.

In more jargonized English, they are asking you to compute
the internal rate of return (IRR) of the series of cash
flows represented by your purchase price, the period
payments of interest by the bond, and the final redemption
of principal of the bond (or cash received from the call, as
the case may be).

The Invest FAQ (http://www.invest-faq.com) has some articles
on IRR and net present value (NPV) that might be of some use
to you.

If you have access to Excel (and quite possibly some other
spreadsheets) check the documentation and online help and
see if there are any financial functions. I know that Excel
can do a number of different IRR calculations and a bunch of
bond amortization and yield calculations. However, those
functions may not be installed by default. You might have
to run Office Setup and install the Analysis Toolpak (or
some similar name) for Excel.

You might have some luck with some financial calculators
(like the HP-12C) as well.
 
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J

Jay

Eric said:
I think I understand about adjusting the basis of a bond
each year for the premium paid for the bond, but what I'm
puzzled by is the exact calculation for the IRS's Constant
Yield Method. Here's a quote from Pub 550 on how to
determine the yield:

Step 1: determine your yield. Your yield is the discount
rate that, when used in figuring the present value of all
remaining payments to be made on the bond (including
payments of qualified stated interest), produces an amount
equal to your basis in the bond. Figure the yield as of the
date you got the bond. It must be constant over the term of
the bond and must be figured to at least two decimal places
when expressed as a percentage.

Could anybody help with an example? Once I know the yield,
I think I can make the basis-adjustment calculations.
There's an Excel template for bond premium amortization at
http://office.microsoft.com/templates/default.aspx
Click on "Personal Finance" first (it's under "Finance and
Accounting"), and then on "Bond Amortization." You can
download the Excel template from there.

To use the spreadsheet, first, fill in the first four
blanks. (Leave "Effective rate" blank at this point.)

Then, use
Tools >> Goal seek
To calculate the "Effective rate" (that is, to "determine
the yield"). Specifically, use "goal seek" to make the final
"Carrying amount of bond" value equal to the "Face value of
the bond" by changing the "Effective rate."

(Disclaimer: I'm not a CPA, just somebody who wanted to
figure out the same stuff.)
 

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