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BOND MATH: The Theory Behind the Formulas by Donald J. Smith

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Premium Bonds

U.S. tax authorities were very busy in the 1980s. After fixing the taxation of market discount bonds originated after 1984, the next task was bonds purchased at a premium. In principle, the premium over par is the present value of the “excessive” coupon payments because the coupon rate is greater than the yield to maturity. You are getting more than you need (in order to pay par value). So, for tax purposes, the investor naturally would want to amortize the premium over the lifetime of the bond. That means reducing the amount of taxable interest income each year.

According to IRS Publication 550, for bonds acquired before 1985, “you can amortize the premium using any reasonable method,” including straight-line amortization and something ...

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