A bond sold at a premium is one trading above its face value, usually because its fixed coupon rate is higher than what newly issued bonds of similar quality are paying. You pay more than par up front, collect the same coupon payments the bond promised at issuance, and receive only the face amount back at maturity. That gap between what you paid and what you get back shapes both your real return and how the IRS treats the bond on your tax return.
Why a Bond Trades Above Par
Bond prices move opposite to market interest rates. When prevailing rates fall, existing bonds locked into higher coupons become more attractive, and buyers bid their prices up until the total return roughly matches what the market currently offers. A bond paying a 6 percent coupon in a 4 percent market will not sell for its face value. It will sell for more.
Credit upgrades push bonds into premium territory too. When a rating agency raises an issuer’s rating, the perceived default risk drops, investors accept a lower yield, and the price rises to reflect that.1S&P Global. Understanding Credit Ratings
What the Premium Does to Your Yield
The coupon rate never changes after issuance, but your actual return depends on what you paid. Three different yield figures tell you different parts of the story.
Current Yield
Current yield is your annual interest income divided by the price you paid, not the face value. Pay $1,100 for a bond with a $1,000 face value and a 5 percent coupon, and you still collect $50 a year. Your current yield is $50 divided by $1,100, or about 4.55 percent.
Yield to Maturity
Yield to maturity accounts for something current yield ignores: the issuer only returns par at maturity, so the premium you paid gradually disappears. For a bond bought at $1,050 with a 6 percent coupon and ten years to maturity, YTM comes out around 5.4 percent, below the coupon, because the $50 premium loss is spread across the remaining life.
YTM also assumes you reinvest every coupon payment at the same rate. In the falling-rate environment that created the premium in the first place, reinvestment opportunities at that rate may not exist. This reinvestment risk grows with higher coupons and longer maturities.2MSRB. Premium Bonds
Yield to Worst
If the bond is callable, the issuer can repay principal early. Yield to worst calculates your return under every possible call date and maturity date and reports the lowest result. For a premium bond, YTW is always less than or equal to YTM, because early repayment compresses the premium loss into a shorter period.3MSRB. Municipal Bond Basics
Call Risk Is the Main Hazard
Call risk is the single biggest exposure for someone buying above par. When rates drop, issuers have a strong incentive to call outstanding bonds and refinance at the new lower rates, which is the same move that pushed those bonds to a premium to begin with. If the bond gets called, you receive par (sometimes with a modest call premium), and any amount you paid above that is gone.
Most bonds carry a call protection period of roughly five to ten years after issuance, during which the issuer cannot call the bond.4FINRA. Callable Bonds: Be Aware That Your Issuer May Come Calling After that window closes, the bond is fair game. Before buying, check the yield to call and compare it against the yield to maturity. The gap tells you how much of your expected return depends on the bond surviving to its full term.
How the IRS Treats the Premium
The IRS lets you recover the cost of the premium through amortization, but the rules differ depending on whether the interest is taxable or tax-exempt.
Taxable Bonds
For bonds paying interest that is subject to federal income tax, you may elect to amortize the premium under Internal Revenue Code Section 171. The amortized premium each year offsets your interest income, reducing the amount you report as taxable.5Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium Skip the election and you report the full coupon each year as interest, then recognize a capital loss when the bond matures or you sell it below your purchase price.
The election is binding. Once you make it, it applies to every taxable bond you hold and every one you buy afterward, for all future years. The IRS can grant permission to revoke, but only under conditions it deems necessary.5Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium
Tax-Exempt Bonds
Buy a municipal or other tax-exempt bond at a premium and amortization is not optional, but it also does not give you a deduction. Section 171(a)(2) states that “no deduction shall be allowed for the amortizable bond premium” when the interest is excludable from gross income.5Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium You still reduce basis each year by the amortized amount. The practical result: no capital loss at maturity, because by then your basis has already been ground down to par.
The Constant Yield Method
For bonds issued after September 27, 1985, the IRS requires the constant yield method rather than a straight-line calculation. Three steps:6Internal Revenue Service. Publication 550 – Investment Income and Expenses
- Determine your yield, the discount rate that, applied to all remaining payments, equals your purchase price. This rate stays fixed for the life of the bond.
- Set your accrual periods, no longer than one year each, typically matching the interest payment intervals.
- For each period, multiply the adjusted acquisition price at the start of the period by your yield. The difference between the stated interest payment and that figure is the premium you amortize for the period.
Because the adjusted acquisition price falls each period as premium is amortized, the interest component shrinks too, which means the amortization amount actually grows over the life of the bond. On a $100,000 bond bought around $108,500 with a 6 percent coupon and a 4 percent market yield, the first year’s amortization runs about $1,659 and rises to roughly $1,941 by the fifth year.
Basis When You Sell Before Maturity
Each year’s amortization reduces your basis in the bond. Section 1016(a)(5) requires this adjustment for both taxable bonds (to the extent of the offset) and tax-exempt bonds (to the extent of the disallowed premium).7Office of the Law Revision Counsel. 26 U.S. Code 1016 – Adjustments to Basis
If you sell before maturity, your gain or loss is measured against adjusted basis, not the original purchase price. Pay $1,100 for a taxable bond, amortize $40 of premium over four years, and your basis is $1,060. Selling at $1,080 gives you a $20 gain, not a $20 loss. The rule blocks a double benefit: you cannot both reduce interest income through amortization and then claim a large capital loss on disposition.5Office of the Law Revision Counsel. 26 U.S. Code 171 – Amortizable Bond Premium
How Amortization Shows Up on Form 1099-INT
For bonds classified as covered securities (most bonds bought through a broker after certain effective dates), your broker calculates the amortization and reports it on Form 1099-INT. The box depends on the bond type:8Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
- Box 11: bond premium amortization on taxable bonds other than Treasuries.
- Box 12: bond premium amortization on U.S. Treasury obligations.
- Box 13: bond premium amortization on tax-exempt bonds.
For taxable bonds, a broker may report the full coupon in Box 1 with the amortization separately in Box 11, or net the two and show only the reduced interest in Box 1. The taxable interest you report should reflect the offset either way. Box 13 for tax-exempt bonds does not produce a deduction; it tracks the required basis reduction.8Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
For bonds that are not covered securities, generally older holdings or bonds held outside a brokerage account, the broker reports only gross interest. You have to run the constant yield calculation yourself and report the amortization on your return.