In connection with the valuation of bonds, some additional considerations should be taken into account. Assuming that the margin of security for the mortgage covering the bonds is ample, the value of a bond, i.e., its price on the market, is largely dependent upon the prevailing interest rate in the money market. Thus, if a bond bearing 5% interest is offered for sale in a market where the rate is 6%, it can be sold only at a discount sufficient to provide approximately 6% on the money invested. Similarly, a 6% bond offered in a 5% market should bring something more than par. It is not intended to convey the impression that whenever a bond sells below par it is because the market is demanding a higher rate than that offered by the bond; nor when a bond sells at a premium need the entire amount of the premium be a reflection of money market conditions. An additional factor is oftentimes the credit standing of the issuing company. Thus, even though a bond may be amply protected, the poor credit rating of the issuing concern will be reflected in a downward tendency of the price of the bond, for under such circumstances foreclosure proceedings preliminary to sale and conversion of the security always loom large in the background. On the other hand, bonds of the United States are often above par because of the government’s credit standing.
On the assumption that there is reasonable expectation that the bonds will be paid at maturity, their valuation on the balance sheet during the time they are held by an investor must have regard to the price paid as determined by the bond interest rate and the money market rate at the time of purchase. A bond bought at a discount and held to maturity is redeemed at par. If the bond is carried at cost until the period of redemption, that period would secure the credit for the difference between cost and par. Similarly for a bond bought at a premium, and carried at cost constantly, the period of redemption would bear the loss between cost and redemption price.
Nature of Bond Discount or Premium
To bring out more clearly the real nature of bond discount or premium, under the limitation stated above, consider a bond selling at 90 and bearing 4½% interest. This should be interpreted to mean that the issuing company, because of the low rate offered on the bond, will have to pay at maturity $1,000 for every $900 now received. It is, as it were, having to prepay $100 interest on every bond sold, in addition to its promise to pay the stipulated bond rate of interest periodically. It is selling a $1,000 security for $900 and is thus depriving itself of $100 which it might have had by contracting to pay the present market rate of interest. From the other (i.e., investor’s) point of view, he is willing to lend money at the bond rate only because he expects to be compensated by the $100 to be received in a lump sum at the maturity of the bond.
The wisdom of fixing the bond interest rate so that the bond will command either a premium or a discount hinges upon the soundness of the forecast as to the money market in the future. It is, of course, a speculative transaction. Since, then, discount on bonds is, from the standpoint of the issuing concern, a prepayment of a portion of the interest in amount sufficient to make the income rate on the bond correspond with the rates prevailing in the market, this prepayment is applicable to the whole period of the life of the bonds and should be spread equitably over that period. To accomplish this it is necessary, every time bond interest is paid, to transfer to the Bond Interest account a portion of the Discount on Bonds account, thus gradually wiping off the Discount account and making the Interest account show every period the real amount (and real rate) of interest as distinguished from the amount paid as indicated by the bond rate.
In the present discussion, the chief concern with the problem of bond discount and premium is from the point of view of the investor. Having established from the other point of view the true relation between premium and discount and bond interest, there will be considered the two additional problems as to the manner of carrying the record on the investor’s books and as to the method of valuing the investment at each balance sheet period. First, then, is the problem of making the record.
Record of Bond Investments
When bonds are purchased the record may be made in two ways. Accounts may be kept with the bonds at par, separate valuation accounts being carried for the discount or premium. An account with bond interest is also opened and sometimes one with prepaid interest on bonds, where, as is usually the case, the bonds are bought with accrued interest to date of purchase. The accrued interest, however, is more conveniently recorded as a charge in the bond interest account, thus automatically adjusting the income from the bonds when the first coupon after date of purchase is redeemed. As stated in Chapter XIV, the amount of the discount or premium is to be spread equitably over the life of the bond. The method of making an equitable distribution is a problem to which consideration will be given in later pages of this chapter. The entry to effect the distribution is a transfer entry between the premium or discount account and the bond interest account for the portion accrued as on the date of each payment on the coupons. The result of the transfer is to establish with the bond account at par a true valuation of the bonds held as on that date, and to secure the correct amount of income from bond interest to be credited to the current period.
The second method of making record of the bond investments is to record the purchases at cost in the bond account, carrying there full information as to premium or discount, no separate accounts with these being opened. When the bond interest falls due, the bond account itself is written up or down for the amount of the discount or premium accrued during the current period. The contra entry is in the bond interest account just as above. This latter method does not commend itself when the only record kept of bonds is that mentioned above. If the investments are so numerous as to require a subsidiary ledger for their record, where with each kind of bond accounts will be kept with its par, discount or premium, and interest, there is no objection to handling the controlling account on the general ledger by making the discount or premium adjustment directly to the bond account. Fuller information is given and the record is less involved, however, when handled by the first method.
Amortization of Bond Discount and Premium