5.3 Fixed Income Accounting: The Interest Method
It is important for the financial analyst to understand bond accounting and its relation to the cost of capital. We will now look at how the accountant illustrates “Maturity Pull” over time. Maturity Pull (see chapter four) has to with the movement over time of a non-Par bond’s carrying value or price towards par as it nears maturity.
In the case of par bonds, the accounting is simple. Non-par bonds are more complicated. The “Interest Method” is the method by which bond premia and discounts are amortized, resulting in a constant application of the discount rate over the horizon. The following is from the perspective of the corporation issuing the bond.
Given
| Principal = $1,000,000 | Coupon = .07 | Discount Rate = .06 (Y-T-M) |
| Annual Payment | Maturity = 3 Years |
Solution
| End of Year | Coupon Interest |
Interest Expense |
Change in Liability (Amortization) |
Debt Balance |
|---|---|---|---|---|
| 0 | $1,026,710 | |||
| 1 | $70,000 | $61,603 | ($8,397) | $1,018,313 |
| 2 | $70,000 | $61,099 | ($8,901) | $1,009,412 |
| 3 | $70,000 | $60,588 | ($9,412) | $1,000,000 |
| Totals | $210,000 | $183,290 | ($26,710) |
Note
Coupon Interest – Interest Expense = Reduction in Liability Balance
$210,000 – $183,290 = ($26,710)
The Interest Expense = Market Discount Rate at the time of issuance ´ proceeds of bond placement, adjusted year-by-year for decreasing balances. Interest expense, including amortization, is tax deductible to the issuing corporation (and taxable to the investor receiving the payment).
In most cases, the issuer of an investment grade bond will try to match the coupon with the current YTM and thus issue the bond at Par (i.e., a multiple of $100). When the coupon and market yield (YTM) are the same, the bond’s dollar price will equal Par. The coupon and other important bond features (e.g., the maturity, size of the issue) will be written into a legal document called a “bond indenture.” The indenture is crafted long before the bond’s issuance. In the time that follows, leading up to the bond’s issuance at the time of the “IPO” (Initial Public Offering), market yields will likely fluctuate. That is why many bonds are usually offered at a premium or discount to par.
In this example, at the time of issuance, the corporation receives a premium of $26,710 above par. At the same time, it is also paying a 7% coupon, which is 1% greater than what it would have to pay if it issued the bond at the current market YTM of 6%. The one percent higher coupon costs the firm .01 × $1,000,000, or $10,000 “extra” a year for the three years. The premium of $26,710 represents the present value of the $10,000, three-year annuity, discounted at the 6% YTM, which is amortized.
At maturity, the issuer will owe the face value (i.e., Par Value) of $1,000,000. The million-dollar amount represents a final, one-time, “balloon” payment. If funds are available, the firm can pay off this balance. Another option is to re-finance by issuing a new bond to pay off the old one.
The accountant and the IRS will recognize the bond’s value based only on its Original Issue Discount Rate (OID) over the life of the bond and not any changes that happen to the YTM over the course of the life of the bond. As a result, the balance that the accountant reports is not indicative of the true value of the bond. Accordingly, the debt ratios calculated using those values will also be incorrect.
