# Reading 16, Blue Box Example 1

Kind of a silly question, but trying to wrap my head around the dynamic of this question as my weakest area is fixed income. This is the Example 1 in the Blue Box for Reading 16. What is the interest payment and interest income and how are they related to amortizing the bond’s value?

In this example, two fictitious companies are used. On 1 January 2011, Baxter Inc. invested £300,000 in Cartel Co. debt securities (with a 6% stated rate on par value, payable each 31 December). The par value of the securities was £275,000. On 31 December 2011, the fair value of Baxter’s investment in Cartel is £350,000.

Assume that the market interest rate in effect when the bonds were purchased was 4.5%.8 If the investment is designated as held-to-maturity, the investment is reported at amortized cost using the effective interest method. A portion of the amortization table is as follows:

Not a silly question. It’s very important we understand this. What gets reported in the P&L is not the coupon rate X face value (that’s often the first inclination when you study this the first time, I used to make the same mistake). Instead, it is the interest rate at the time of purchase (4.5%) X the purchase price (and reported in the P&L for HTM securities). The difference between interest income and interest payment is the amortization. Amortization is how the ending book value each year declines from the \$300,000 purchase value to the \$275,000 face value value. Amortization here is negative because the purchase value is higher than the face value (it’s a premium bond). This is because the coupon rate is higher than the interest rate at the time of purchasing the bond. You should follow-up on this from your level 1 FI book if this is still unclear. If it were a discount rate (e.g if the interest rate at the time of purchasing were 7%, or higher than the 6% coupon rate), the amortization each year would be positive such that the ending book value of the bond each year would slowly increase to the \$275,000 face value. Read and practice example 1 a few hundred times before you’re 100% clear on what’s happening. This section is super important.