The Constant Yield Method: Calculation and Tax Rules
Understand the standard accounting method used to smooth out bond interest income, reconciling the purchase price with taxable earnings over the investment's life.
Understand the standard accounting method used to smooth out bond interest income, reconciling the purchase price with taxable earnings over the investment's life.
The constant yield method is an accounting technique for the amortization of a premium or discount on a debt instrument, such as a bond. This approach ensures that the rate of return on the book value remains uniform throughout the holding period of the investment. The Internal Revenue Service (IRS) mandates this method when a bond’s purchase price is different from its face value. This process effectively spreads any gain from a discount or loss from a premium over the bond’s life.
To accurately perform the constant yield method calculation, several pieces of information are necessary. The difference between the acquisition price and the face value determines if the bond was purchased at a premium (price > face value) or a discount (price < face value).
The application of the constant yield method is a periodic process that adjusts a bond’s basis. The first step is to establish the initial adjusted basis, which is the acquisition price paid for the bond. The next step is to calculate the interest income for the period by multiplying the adjusted basis at the beginning of the period by the bond’s yield to maturity (YTM). The YTM must be adjusted to match the accrual period; for instance, a semi-annual period requires using half of the annual YTM.
Following the interest income calculation, the amortization amount for the period is determined. This is the difference between the interest income just calculated and the actual cash coupon payment received. The coupon payment is found by multiplying the bond’s face value by its stated coupon rate, also adjusted for the length of the accrual period.
To illustrate, consider a five-year bond with a $1,000 face value and a 4% semi-annual coupon, purchased for $980. The YTM is calculated to be 4.451%. In the first semi-annual period, the interest income would be $21.81 ($980 adjusted basis x 2.2255% semi-annual YTM). The cash coupon payment is $20 ($1,000 face value x 2% semi-annual coupon rate). The amortization amount for this period is the difference, which is $1.81.
The final step is to calculate the new adjusted basis for the start of the next period. For a bond purchased at a discount, the amortization amount is added to the beginning basis. In the example, the new adjusted basis would be $981.81 ($980 + $1.81). If the bond had been purchased at a premium, the amortization amount would be subtracted. This process is repeated for each accrual period, systematically adjusting the bond’s basis until it equals the face value at maturity.
The constant yield method directly impacts how an investor reports income to the IRS. The interest income figure calculated each period using this method is the amount that must be reported as taxable income, not the cash coupon payment received. This ensures that the economic accrual of interest is taxed. For bonds purchased at a discount, this means reporting income that is greater than the cash received.
A key concept is Original Issue Discount (OID), which occurs when a bond is first issued for a price less than its redemption value. The IRS mandates the use of the constant yield method to calculate the amount of OID that must be included in the bondholder’s gross income each year. This annual OID inclusion is reported on Form 1099-OID, and the accreted value is added to the bond’s cost basis.
Conversely, when a bond is purchased for more than its face value, a bond premium occurs. Investors can elect to amortize this premium under IRC Section 171. Using the constant yield method, the calculated amortization amount reduces the amount of taxable interest income reported by the investor. This election, once made, applies to all taxable bonds owned by the investor and cannot be easily revoked.