What Is an Amortizable Bond Premium?

The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis.

Understanding an Amortizable Bond Premium

A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.

The difference between the bond’s current price (or carrying value) and the bond’s face value is the premium of the bond. For example, a bond that has a face value of $1,000 but is sold for $1,050 has a $50 premium. Over time, as the bond premium approaches maturity, the value of the bond falls until it is at par on the maturity date. The gradual decrease in the value of the bond is called amortization.

Cost Basis

For a bond investor, the premium paid for a bond represents part of the cost basis of the bond, which is important for tax purposes. If the bond pays taxable interest, the bondholder can choose to amortize the premium—that is, use a part of the premium to reduce the amount of interest income included for taxes.

Those who invest in taxable premium bonds typically benefit from amortizing the premium, because the amount amortized can be used to offset the interest income from the bond. This, in turn, will reduce the amount of taxable income the bond generates, and thus any income tax due on it as well. The cost basis of the taxable bond is reduced by the amount of premium amortized each year.

In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year. The IRS requires that the constant yield method be used to amortize a bond premium every year.

Amortizing Bond Premium With the Constant Yield Method

The constant yield method is used to determine the bond premium amortization for each accrual period. It amortizes a bond premium by multiplying the adjusted basis by the yield at issuance and then subtracting the coupon interest. Or in formula form:

• Accrual = Purchase Basis x (YTM /Accrual periods per year) – Coupon Interest

The first step in calculating the premium amortization is to determine the yield to maturity (YTM), which is the discount rate that equates the present value of all remaining payments to be made on the bond to the basis in the bond.

For example, consider an investor that purchased a bond for $10,150. The bond has a five-year maturity date and a par value of $10,000. It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%. Let’s calculate the amortization for the first period and second period.

The First Period

Since this bond makes semi-annual payments, the first period is the first six months after which the first coupon payment is made; the second period is the next six months, after which the investor receives the second coupon payment, and so on. Since we’re assuming a six-month accrual period, the yield and coupon rate will be divided by 2.

Following our example, the yield used to amortize the bond premium is 3.5%/2 = 1.75%, and the coupon payment per period is 5% / 2 x $10,000 = $250. The amortization for period 1 is as follows:

• Accrual_period1 = ($10,150 x 1.75%) – $250
• Accrual_period1 = $177.63 – $250
• Accrual_period1 = -$72.38

The Second Period

The bond’s basis for the second period is the purchase price plus the accrual in the first period—that is, $10,150 – $72.38 = $10,077.62:

• Accrual_period2 = ($10,077.62 x 1.75%) – $250
• Accrual_period2 = $176.36 – $250
• Accrual_period2 = -$73.64

For the remaining eight periods (there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years), use the same structure presented above to calculate the amortizable bond premium.

Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes.

What Is an Alternative Investment?

An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Alternative investments can include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.

Understanding Alternative Investments

Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, lack of regulation, and degree of risk. Many alternative investments have high minimum investments and fee structures, especially when compared to mutual funds and exchange-traded funds (ETFs). These investments also have less opportunity to publish verifiable performance data and advertise to potential investors. Although alternative assets may have high initial minimums and upfront investment fees, transaction costs are typically lower than those of conventional assets due to lower levels of turnover.

Most alternative assets are fairly illiquid, especially compared to their conventional counterparts. For example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared to 1,000 shares of Apple Inc. due to a limited number of buyers. Investors may have difficulty even valuing alternative investments, since the assets, and transactions involving them, are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as there are only 13 known to exist and only one can be legally owned.

Regulation of Alternative Investments

Even when they don’t involve unique items like coins or art, alternative investments are prone to investment scams and fraud due to the lack of regulations.

Alternative investments are often subject to a less clear legal structure than conventional investments. They do fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to examination by the U.S. Securities and Exchange Commission (SEC). However, they usually don’t have to register with the SEC. As such, they are not overseen or regulated by the SEC as are mutual funds and ETFs.

So, it is essential that investors conduct extensive due diligence when considering alternative investments. In some cases, only accredited investors may invest in alternative offerings. Accredited investors are those with a net worth exceeding $1 million—not counting their primary residence—or with an annual income of at least $200,000 (or $300,000 combined with a spousal income). Financial professionals who hold a FINRA Series 7, 65, or 82 license may also qualify as an accredited investor.

Strategy for Alternative Investments

Alternative investments typically have a low correlation with those in standard asset classes. This low correlation means they often move counter to the stock and bond markets. This feature makes them a suitable tool for portfolio diversification. Investments in hard assets, such as gold, oil, and real property, also provide an effective hedge against inflation, which hurts the purchasing power of paper money.

Because of this, many large institutional funds such as pension funds and private endowments often allocate a small portion of their portfolios—typically less than 10%—to alternative investments such as hedge funds.

The non-accredited retail investor also has access to alternative investments. Alternative mutual funds and exchange-traded funds—also called alt funds or liquid alts—are now available. These alt funds provide ample opportunity to invest in alternative asset categories, previously difficult and costly for the average individual to access. Because they are publicly traded, alt funds are SEC-registered and regulated, specifically by the Investment Company Act of 1940.

Example of Alternative Investments

Just being regulated does not mean that alt funds are safe investments. The SEC notes, “Many alternative mutual funds have limited performance histories.”

Also, although its diversified portfolio naturally mitigates the threat of loss, an alt fund is still subject to the inherent risks of its underlying assets. Indeed, the track record of ETFs that specialize in alternative assets has been mixed.

For example, as of January 2022, the SPDR Dow Jones Global Real Estate ETF had an annualized five-year return of 6.17%. In contrast, the SPDR S&P Oil & Gas Exploration & Production ETF posted a return of –6.40% for the same period.

What Is a 100% Equities Strategy?

A 100% equities strategy is a strategy commonly adopted by pooled funds, such as a mutual fund, that allocates all investable cash solely to stocks. Only equity securities are considered for investment, whether they be listed stocks, over-the-counter stocks, or private equity shares.

Understanding a 100% Equities Strategy

100% equities strategies represent portfolios that only select investments from the equities (i.e., stocks) universe. 100% equity strategies are predominant in the market and encompass a large majority of offerings.

In practice, many 100% equity strategies will have an investment objective or mandate to invest at least 80% in equities. The 80% threshold is a formality used in regulatory or registration documentation for the majority of equity funds in the marketplace, with many funds deploying anywhere from 90% to 100% to equities.

100% equity means that there will be no bonds or other asset classes. Furthermore, it implies that the portfolio would not make use of related products like equity derivatives, or employ riskier strategies such as short selling or buying on margin. Instead, 100% equities implies a more focused, traditional approach to equity investment.

Special Considerations

Equities are generally considered a riskier asset class over alternatives such as bonds, money market funds, and cash.

A well-diversified portfolio of all stocks can protect against individual company risk, or even sector risk, but market risks will still persist that can affect the equities asset class. Thus, both systemic and idiosyncratic risks are important considerations for aggressive equity investors. As a result, most financial advice recommends a portfolio that includes both equity and fixed-income (bond) components.

100% Equities Strategy Types

In the 100% equity strategy category, an investor will find a wide range of sub-classes to choose from, including those that focus on one (or a combination of) labels like capital appreciation, aggressive growth, growth, value, and income. Outlined below are some of the characteristics investors can expect from some of the most prominent 100% equity strategies.

Growth

Growth investing is a style used by many aggressive equity investors who are comfortable with higher-risk investments and seek to take advantage of growing companies. The Russell 3000 Growth Index is a broad market index that helps to represent the growth category.

Growth companies offer emerging technologies, new innovations, or a significant sector advantage that gives them above average expectations for revenue and earnings growth.

Value

Value stocks are often known as long term core holdings for an investor’s portfolio. These equity funds will rely on fundamental analysis to identify stocks that are undervalued in comparison to their fundamental value.

Investment metrics for value investing often include price-to-earnings, price-to-book, and free cash flow.

Income

Income investing is also a top category for core long-term holdings in a portfolio. Income funds will invest in equities with a focus on current income. Income from equity investments is primarily focused on mature companies paying steady dividend rates.

In the income category, real estate investment trusts and master limited partnerships are two publicly traded stock categories with unique incorporation structures that require them to pay high levels of income to equity investors.

Market Capitalization

Capitalization is a popular investing strategy for all equity portfolios. Generally, capitalization is broken down by large cap, mid cap, and small cap.

Large-cap companies can offer the lowest volatility as they have established businesses and steady earnings that pay dividends. Small-cap companies, on the other hand, are usually considered to have the highest risk since they are typically in the early stages of their development.

What Are China A-Shares?

China A-shares are the stock shares of mainland China-based companies that trade on the two Chinese stock exchanges, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE). Historically, China A-shares were only available for purchase by mainland citizens due to China’s restrictions on foreign investment.

However, since 2003, select foreign institutions have been able to purchase these shares through the Qualified Foreign Institutional Investor (QFII) system. Established in 2002, the QFII program allows specified licensed international investors to buy and sell on mainland China’s stock exchanges.

A-shares are also known as domestic shares because they use the Chinese renminbi (RMB) for valuation.

China A-Shares vs. B-Shares

China A-shares are different from B-shares. A-shares are only quoted in RMB, while B-shares are quoted in foreign currencies, such as the U.S. dollar, and are more widely available to foreign investors. Foreign investors may have difficulty accessing A-shares because of Chinese government regulations, and Chinese investors may have difficulty accessing B shares most notably for currency-exchange reasons. Some companies opt to have their stock listed on both the A-shares and B-shares market.

Due to the limited access of Chinese investors to B-shares, the stock of the same company often trades at much higher valuations on the A-shares market than on the B-shares market. Although foreign investors may now invest in A-shares, there is a monthly 20% limit on repatriation of funds to foreign countries.

The Shanghai Stock Exchange (SSE) publishes the key performance index for A-shares, known as the SSE 180 Index. In composing the index, the exchange selects 180 stocks listed on the SSE. The selection is diversified between sector, size, and liquidity to ensure adequate representation. Thus, the index’s performance benchmark reflects the overall situation and operation of the Shanghai securities market.

History of China A-Shares

Since its inception in 1990, including a major reform in 2002, the index has seen great fluctuations. However, it has grown along with the Chinese economy. The years 2015 to 2016 were a particularly difficult period, with a 52-week performance of -21.55% as of July 20, 2016.

As China grows from an emerging market to an advanced economy, there is substantial demand for Chinese equity. Stock exchange regulators continue efforts to make A-shares more broadly available to foreign investors and have them recognized by the global investing community.

In June 2017, the MSCI Emerging Markets Index announced a two-phase plan in which it would gradually add 222 China A large-cap stocks. In May 2018, the index began to partially include China large-cap A shares, which make up 5% of the index. Full inclusion would make up 40% of the index.

It is important for countries such as China to open their markets to global investors to stay competitive and thrive economically. China A-shares provide an alternative investment for those interested in trading in Chinese securities.