I have a question and sorry if i am asking a dumb one. in level 1 it talks extensively about amortization, about how if a bond is issued at a premium for example, with every interest payment you receive the bond is amortizewd down to par.
So i’ve always thought all bonds amortizes. But i was speaking with a coworker today and he says no, amorziation is mainly for instruments that do paydowns like mortages/cmo.
So…what am i missing? Also when calculating GL on a bond, don’t you use current market price of bond - amortized price of bond to calculate GL ( to acccount for the interest payment you receive)?
thanks
very confused…
Looking back, it seems like what it is trying to say is looking at it from the bond issuer’s standpoint, the bond amoritzes, but i guess looking at it from a bond buyer’s standpoint, the bond doesn’t amortize…is that right?
You and your coworker are talking about two very different ideas.
You’re talking about amortizing the premium or discount on a normal (coupon-only) bond. Suppose that you buy a 10-year bond with a par value of $1,000; you pay $1,100. Over the next 10 years you have to reduce the value of that bond from $1,100 to $1,000 via amortization. The simple way to do it is straight-line: $10 per year. The preferred (but more complicated) way to do it is to use the YTM when you purchased the bond to compute your interest income each year; the difference between your interest income and the coupon payment you receive is the amortization amount that you subtract from the book value of the bond. At maturity, you will receive the last coupon payment plus the $1,000 par payment.
Your coworker is talking about amortizing bonds, such as mortgage-backed securities (MBSs). These bonds typically make payments monthly, and each payment comprises some principal and some interest. Over the life of the bond, the principal payments reduce the outstanding value of the bond, so that at the final payment the bond is paid off: there is no additional par payment at the end.
I wrote an article on amortization that covers mortgages and bond premia/discounts, in addition to finance leases; you can find it here: http://www.financialexamhelp123.com/amortization-tables/
Full disclosure: as of 4/25/16, there is a fee to subscribe to my website to get access to all of the articles I’ve written.