Amortization and Accretion

What are amortization and accretion?

When investors buy fixed-income securities, they often purchase them at prices above or below face (or par) value, depending on what has happened in the market. Buying higher than face value is known as buying at a premium. Buying less than face value is known as buying at a discount.

Amortization or accretion calculations are used to adjust the cost basis from the purchase amount to the expected redemption amount. This spreads out the gain or loss over the remaining life of the bond instead of recognizing the gain or loss in the year of the bond’s redemption.

How are amortization and accretion handled in Morningstar Office?

The Amortization Wizard is used to generate the amortization transactions in batches with the specified time period, security type, and other settings. "Amortization" is a new transaction type for fixed income securities (Fixed Income, Collateralized Mortgage Obligations, Mortgage-Backed Securities). Amortization transactions will have no impact on cash balance or share balance, but they will affect cost and income calculations. Reporting settings for the Amortization transaction type will impact calculations as follows:

If "Amortization Reported as" is set to...

Then...

None

Cost basis is affected

Income

Cost basis and income are affected

Default Tax Setting

See Tax Treatment of Bond Premiums

The adjustment type "Amortization" decreases cost and decreases income; the adjustment type "Accretion" increases cost and increases income.

Reports Affected by Amortization Transactions

The table below lists the Morningstar Office reports impacted by amortization.

Report Name

Related Data Points

1099 Consolidated

Amount of Income

Account Summary

Cost Basis

Asset Reconciliation

Realized Gain

Client Position Summary
by Account/Security

Unit Cost

Performance Summary

Period Realized Gain/Loss
Period Unrealized Gain/Loss

Point-to-Point Gain/Loss

Actual Realized Gain/Loss

Portfolio Current Value by Security/Security Type/
Asset Class

Total Cost
Unit Cost

Portfolio Summary by
Asset Class/Security Type

Total Cost
Unit Cost

Realized Gain/Loss

Cost
Long Term Gain
Short Term Gain
Total Gain

Security Cross Reference

Total Cost
Unrealized Gain

Unrealized Gain/Loss

Total Cost
Unit Cost
Short Term
Unrealized Gain/Loss Long Term Unrealized Gain/Loss
% Gain/Loss

Tax Treatment of Bond Premiums/Discounts

Premium Bond

Premium/Discount

Cost Basis/Income

Taxable

Can be amortized to maturity amortization

Reduced cost basis and income to reflect amortization

Tax-exempt
(for municipal bonds)

Must be amortized to maturity

Reduced cost basis to reflect amortization, not deductible to income

Market Discount Bond

 

 

Taxable

At sale, taxable income generated on accrued interest and taxable capital gain
(price minus basis)

Increased to reflect accrual of the discount

Tax-exempt
(for municipal bonds)

Adjusted

Amortization Methods for Premium Bonds

Bond Age

Calculation

Issued on or before 9/27/85

Straight line or constant yield

Issued after 9/27/85

Constant yield only

Accretion/Accrual of Discount for Market Discount Bonds

Bond Age

Calculation

Issued on or before 7/18/84 and bought on or before 4/30/93

No accrual

Issued after 7/18/84 or bought after 4/30/93

Constant yield

The de minimis rule

The de minimis rule governs the treatment of small amounts of market discount. Under the de minimis rule, if a bond is purchased at a small market discount—an amount less than 0.25 percent of the face value of a bond times the number of complete years between the bond's acquisition date and its maturity date—the market discount is considered to be zero. If the market discount is less than the de minimis amount, the discount on the bond is generally treated as a capital gain upon disposition or redemption rather than as ordinary income.

Other Assumptions

Constant Yield Method

The constant yield method calculates an adjustment schedule from the acquisition date to the redemption date, extracting the per period amounts from this schedule. The premium amount is adjusted across the life of the bond using the Yield at Purchase rate. You can use this method only for fixed income securities.

This formula is used for amortized amount per period:

Amortized Amount = Accrual Period Interest – (Beginning Basis x Yield at Purchase)

Accrual Period Interest is calculated as the annual interest amount by multiplying the face value of the bond on the payment date by the Interest Rate. Then this number is converted into a value relative to the payment periods.

Beginning Basis is the cost basis as of the beginning date of the accrual period. This value is usually different for each period.

Yield at Purchase - If the opening transaction (buy, credit, or receipt) contains a yield at purchase value, that number will be used in the amortization formula. Otherwise, the system calculates and uses its own yield to maturity (YTM) at cost.

Note: When entering yield at purchase in the opening transaction, enter the annual yield. The yield value is adjusted according to the accrual period, such as annual, semi-annual, or quarterly. For example, if the payment frequency is semi-annual, the system divides the yield by 2. If the frequency is quarterly, the system divides the yield by 4.

Straight Line Method

The straight-line method calculates an evenly distributed amortization or accretion schedule across the life of the bond, spreading the premium or discount amount evenly over all periods. You can use this method with all bond security types: fixed income, mortgage-backed, and T-Bills.

Amortized Amount = Premium / Total Accrual Periods

Remember, the premium (or discount) is the difference between what you paid for a bond and the total of all amounts (minus qualified stated interest) payable on the bond through redemption. For example, if you pay $1,025 for a $1,000 maturity bond, your premium is $25.

Total Accrual Periods are the number of standard length adjustment periods from acquisition to redemption, and it is determined by the amortization frequency in the security type settings and the day type and redemption date in the security details.