A bond premium is the amount you pay above a bond’s face value when you buy it, and it exists because the bond’s fixed coupon is higher than what newly issued bonds of similar quality currently pay. That extra cost is not lost money in the ordinary sense. It gets absorbed across the bond’s remaining life through a process called amortization, which lowers your cost basis each year and, depending on the bond type, may also reduce the interest income you report on your tax return.
Why Bonds Trade Above Par
Bond prices and interest rates move in opposite directions. When prevailing rates fall, a bond carrying a higher fixed coupon suddenly looks generous compared to new issues. Buyers bid the price up until the effective yield a new purchaser earns roughly matches what’s available elsewhere in the market. That price bump above par is the premium.
The intuition is simple. If a bond pays 6% annually while new issues offer only 4%, nobody sells that 6% bond at face value. The seller wants compensation for giving up above-market income, and the buyer accepts a higher entry price in exchange for larger interest checks. The premium equalizes returns across bonds with different coupon rates. Everything that follows about amortization and taxes is really just accounting for that initial overpayment.
Sizing the Premium
Par value is what the issuer pays back at maturity. Corporate and municipal bonds in the United States typically carry a par value of $1,000 per bond.1Municipal Securities Rulemaking Board. Municipal Bond Basics Subtract that $1,000 from whatever you paid, and the difference is your premium. Pay $1,050 for a $1,000 bond, and the premium is $50.
Bond prices are usually quoted as a percentage of par rather than in dollars. A quote of 105 means the bond sells at 105% of face value, or $1,050 on a standard $1,000 bond. A quote of 98.5 signals a discount. Anything above 100 signals a premium.
The Yield Number That Actually Matters
When a premium bond is callable, the yield to maturity you see quoted can overstate what you will really earn. The issuer can redeem a callable bond before maturity, typically at par, meaning you would receive less than you paid. Yield to worst is the more honest figure because it reflects the lowest return you could earn across all call dates and the maturity date. For bonds trading above par, yield to worst almost always equals the yield to call, because an early call cuts short the run of above-market coupons and hands you back par sooner than you planned.
The Call Risk That Bites Back
Here’s the scenario people miss. You buy a bond at $1,050 for its 6% coupon. Rates keep falling. The issuer refinances by calling the bond at par. You get $1,000 back, not the $1,050 you paid, and the coupon payments stop. The higher income stream you paid to access vanishes, and you’re left reinvesting in a market where yields are lower than when you started.
Callable bonds carry both call risk and reinvestment risk, and the issuer times the call to their own benefit, which is when rates have fallen far enough to make refinancing worthwhile. FINRA notes that when a call happens, it may be difficult or impossible to find a replacement bond with a similar risk profile at the same rate of return.2FINRA. Callable Bonds: Be Aware That Your Issuer May Come Calling Before you buy any premium bond, check whether it’s callable and read the call schedule. If the first call date is a year or two out, the premium is at serious risk.
Why Investors Still Pay Up
Premium bonds remain popular for practical reasons. The higher coupon delivers more cash each period, which matters for retirees and institutions that depend on predictable income. A 6% coupon on a $1,000 bond produces $60 a year whether you paid $1,000 or $1,050 for it.
Premium bonds also tend to hold their price better when rates rise. Because they already pay above-market coupons, their prices don’t drop as steeply as discount bonds when new issues start offering higher yields. The higher coupon effectively shortens the bond’s duration, which is the technical measure of interest rate sensitivity. That gives investors worried about rising rates a modest cushion.
There is a tax angle as well. Discount bonds can generate phantom income under original issue discount rules or produce capital gains at redemption. Premium bonds work in the other direction on taxable issues: the premium can offset interest income each year, potentially reducing your annual tax bill. The trade-off between entry price and tax treatment deserves modeling before you buy.
How Premium Amortization Works
Amortization spreads the premium across the bond’s remaining life so the book value declines to par by maturity. The IRS requires the constant yield method for bonds issued after September 1985. Three steps drive it.
First, calculate the holder’s yield, which is the discount rate that makes the present value of the remaining payments equal to the price you paid. That yield stays constant for the life of the bond and must be figured to at least two decimal places. Second, identify the accrual periods, which usually match the bond’s coupon schedule. Third, for each period, take the stated interest payment and subtract the adjusted acquisition price times the holder’s yield. The difference is the premium amortized for that period.3eCFR. 26 CFR 1.171-2 – Amortization of Bond Premium
Each time you amortize a portion of the premium, the bond’s adjusted acquisition price drops. By maturity, the acquisition price equals par, so there’s no sudden loss when the issuer pays back face value. Brokerages handle this automatically for covered securities, which includes bonds purchased after January 1, 2013.
Tax Rules for Taxable Bonds
On taxable bonds, amortizing the premium is optional. If you elect to amortize, the amortized amount offsets your interest income each year, reducing the taxable portion of your coupons.4Office of the Law Revision Counsel. 26 USC 171 – Amortizable Bond Premium If you don’t elect, you report the full coupon as interest income and keep the premium in your cost basis, which reduces any capital gain (or increases any loss) when you sell or the bond matures.
Amortizing usually makes sense, because it converts what would otherwise be a capital loss at maturity into annual reductions in ordinary income, which is typically taxed at a higher rate. But the election has strings.
Making the Election
You make the election by offsetting interest income with bond premium on a timely filed federal return for the first year you want it to apply, and attaching a statement indicating you’re making the election under Section 171.5eCFR. 26 CFR 1.171-4 – Election to Amortize Bond Premium on Taxable Bonds Once made, the election covers every taxable bond you hold that year and every taxable bond you acquire in future years.
The election is essentially permanent. You cannot revoke it without written approval from the IRS Commissioner, which requires filing Form 3115 as a change in accounting method.5eCFR. 26 CFR 1.171-4 – Election to Amortize Bond Premium on Taxable Bonds Think it through before you file, because you’re locking in the treatment for your entire taxable bond portfolio going forward.
Basis and Reporting
If you elect to amortize, you must reduce your cost basis each year by the amount of premium amortized.6Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis That prevents double-dipping: you can’t deduct the premium against interest income and then also claim a capital loss for the same premium at maturity. If you don’t elect, the full premium stays in basis until you sell or the bond matures.
On the return, bond interest goes on Schedule B (Form 1040), line 1. Below your last interest entry, add a subtotal, then subtract the amortizable bond premium for the year, labeling the subtraction “ABP Adjustment.” Carry the net figure forward.7Internal Revenue Service. Publication 550 – Investment Income and Expenses
Tax Rules for Tax-Exempt Bonds
Municipal bonds and other tax-exempt securities follow a stricter rule. You must amortize the premium, and you get no deduction for it.4Office of the Law Revision Counsel. 26 USC 171 – Amortizable Bond Premium There is no election. The premium simply erodes your basis over time without producing any tax benefit, and basis still has to be reduced each year by the amortized amount.6Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
This matters most if you sell the bond before maturity. Failing to track the declining basis leads to an incorrect capital gain or loss. The IRS expects your basis to reflect the cumulative amortization even though you never got a deduction, and getting it wrong can produce underreported gain on Schedule D.8Internal Revenue Service. 2025 Instructions for Schedule D (Form 1040)
What Your 1099-INT Will Show
For covered securities, brokerages report bond premium amortization on Form 1099-INT. The box depends on the type of bond:
- Box 11 for bond premium on taxable covered securities other than Treasuries
- Box 12 for bond premium on U.S. Treasury obligations
- Box 13 for bond premium on tax-exempt bonds
Brokers can present the amortization two ways. They may put a net interest figure in Box 1 that already reflects the premium offset and leave the premium box blank. Or they may report gross interest in Box 1 and the premium amortization separately in the applicable box.9Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID If you receive $20 of interest and $2 of premium amortization, the broker may report either $18 in Box 1 with Box 11 blank, or $20 in Box 1 and $2 in Box 11. Either way, you owe tax on $18. Confirm which method your broker uses before you fill out Schedule B, so you don’t subtract the amortization twice.
For taxable covered securities, brokers default to amortizing unless you tell them you don’t want the election. For noncovered securities purchased before 2013, the broker reports only gross interest and the amortization tracking is entirely on you.7Internal Revenue Service. Publication 550 – Investment Income and Expenses
Selling Before Maturity
If you sell early, gain or loss depends on adjusted basis at the sale date. For an amortizing investor, basis has been declining each year by the amortized amount. Pay $1,050, amortize $30 across several years, and sell for $1,040: adjusted basis is $1,020 and the capital gain is $20.
If you never elected to amortize on a taxable bond, your full $1,050 purchase price stays as basis. Selling at $1,040 would produce a $10 capital loss. Whether you amortize or not doesn’t change the total economics of the investment. What changes is the timing and the character of the tax consequences, which depend on your bracket and the rest of your portfolio.