How does bond premium amortization work under the effective interest method, and why does interest expense decrease over time?

When a bond is purchased at a premium (price > face value), the buyer paid more than par because the coupon rate exceeds the market yield at purchase. The premium is amortized over the bond's life, gradually reducing the carrying value to par at maturity.

Effective Interest Method

Each period:

1. Interest expense = Carrying value x Market yield (at purchase)
2. Coupon payment = Face value x Coupon rate
3. Premium amortization = Coupon payment - Interest expense
4. New carrying value = Old carrying value - Premium amortization

Because the carrying value decreases each period, interest expense (which is a percentage of carrying value) also decreases.

Example: Crestview Investments buys a $1,000,000 face value bond at 104 (i.e., $1,040,000). The coupon rate is 6% paid annually, and the market yield at issuance is 5%. The bond matures in 4 years.

*Note: Slight rounding; the final carrying value converges to $1,000,000 with exact calculations.

Why Interest Expense Decreases

Each period the premium amortization reduces the carrying value. Since interest expense is calculated on this declining carrying value, the expense shrinks. Meanwhile, the coupon stays fixed. The growing gap between the coupon and interest expense means amortization accelerates over time.

Discount Bonds -- Opposite Pattern

For bonds purchased at a discount, the carrying value increases toward par, so interest expense grows each period and the discount amortization also accelerates.

Income Statement vs. Cash Flow

• Interest expense ($52,000 in Year 1) is the income statement charge.
• Coupon payment ($60,000) is the actual cash outflow.
• The difference ($8,000 premium amortization) is a non-cash adjustment.

Exam Tip: The effective interest method is the only method allowed under IFRS. US GAAP allows the straight-line method if results are not materially different. The exam almost always uses the effective interest method.

Practice bond amortization schedules in our CFA Level I FRA question bank.