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:

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.

Tax Treatment of Bond Premiums/Discounts

Amortization Methods for Premium Bonds

Accretion/Accrual of Discount for Market Discount Bonds

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

• The total life of the investment, for purposes of the amortization, shall commence on the date of purchase and continue until the maturity date of the particular security.

• When fixed income securities are disposed of before their maturity date, the gain or loss to be recorded on the sale is the difference between the net proceeds from the sale and the adjusted cost basis of the securities at the time of sale.

• For Treasuries, Agencies, Corporate, ABS and Municipals, the Constant Yield amortization method is used.

• If the amount of your bond premium amortization for an accrual period is more than the qualified stated interest for the period, you can deduct the difference as a miscellaneous itemized deduction on Schedule A (Form 1040), line 28, but your deduction is limited to the amount by which your total interest inclusions on the bond in prior accrual periods is more than your total bond premium deductions on the bond in prior periods. Any amount you cannot deduct because of this limit can be carried forward to the next accrual period.

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.

Notes:

For TD Ameritrade:

• Bonds are amortized as an offset to interest income utilizing the constant yield method.

• If applicable, calculations are applied daily.

For Schwab:

• If applicable, calculations are applied daily.