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What Is Accretion (of a Discount)?
Accretion, the reduction in discount value, benefits investors by increasing the value of their fixed income investments over time, as the present value of future cash flows increases relative to the initial discount purchased at.
Oct 17, 2024 at 12:53 pm
1. Definition of Accretion
Accretion refers to the gradual reduction in the discount value of a debt obligation over time. It occurs when the market value of the debt increases, or the present value of its future cash flows increases, resulting in a decrease in the discount applied to the debt's face value.
2. Significance of Accretion
Accretion is important for investors who purchase debt obligations or fixed income securities at a discount. As the debt matures, the decrease in the discount value leads to an increase in the value of the investment.
3. Calculation of Accretion
To calculate the accretion, the following steps are involved:
- Determine the original discount: This is the difference between the market value of the debt and its face value or par value.
- Estimate the effective interest rate: This is the implied interest rate that equates the present value of the future cash flows to the purchase price of the debt.
- Calculate the periodic interest payment: Multiply the effective interest rate by the carrying value of the debt.
- Reduce the discount: Subtract the periodic interest payment from the original discount to arrive at the new discount value.
4. Factors Affecting Accretion
The rate of accretion is influenced by several factors, including:
- Interest rate changes: Rising interest rates lead to a faster reduction in the discount value, while falling interest rates result in slower accretion.
- Credit risk: Debts with higher credit risk have wider discounts, resulting in faster accretion compared to lower-risk debts.
- Maturity date: The closer a debt is to its maturity date, the smaller the discount and the slower the accretion rate.
5. Accounting Treatment of Accretion
For accounting purposes, accretion is recognized over the life of the debt and reported as an increase in the carrying value of the debt. This results in periodic interest income that is recognized even if no cash payments are received from the debtor.
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