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Introduction to Held to Maturity Security

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Pros and Cons

They are several factors and investment objectives which depend on the functionality of such securities which also highlights their benefits and drawbacks.

Pros

Such securities are considered relatively ‘safe’ investments with minimum or no risks involved. One instance can be of Government bonds which do offer fewer returns but it indicates guaranteed return and also the safety of the investments made depending on the economic situation of the country.

Held to Maturity securities have a relatively predictable and pre-determined return which is locked at the time of purchase. This makes them resilient against fluctuations in the market.

Investors can consider long-term financial plans on the basis of these Held to Maturity securities as the purchaser has accurate details about how much return will they extract and at what point of time.

Reclassification of securities in a portfolio to Held to Maturity can offer stable ratios to the overall profitability.

Cons

These securities are not a feasible option for investors who require liquidation opportunities in the short term.

Since the level of returns is fixed and pre-determined, there is no probability of substantially high returns if the market is going through a bullish phase.

Held to Maturity Security Examples

Let’s assume on Jan 1, 2014, XYZ Ltd. purchased 1 million bonds worth $100 of KL Ltd. carrying annual coupons @ 7% with a maturity of 20 years for $93.57 million. These bonds have an effective rate of interest @ 8%.

XYZ Ltd. has the intention to hold these bonds till maturity so they are classified as Held to maturity (HTM) and the acquisition is recorded as below:

Investment in Bonds of KL. Ltd

100 million

Cash

93.57 million

Discount on Bonds

6.43 million

For the year ended 31st December 2014 the interest income on the bonds would be equal to the product of the bonds’ carrying amount and effective interest rates which = $7.49 million [$93.57mm * 8%]

Interest receivable for the time period = $7mm [contractual coupon rate of 7% applicable on the face value of bonds worth $100mm]. The difference between interest receivable and interest income is the amortization of discount and the interest income is realized as:

Interest Receivable 7 million

Discount on Bonds 0.49 million

Interest Income

7.49 million

On December 31st, 2014, the bonds will be shown at $94.06mm ($93.57 mm plus $0.49mm). The discount on the bonds recognized upon the acquisition of the bonds will expire over the life on the bonds i.e. 20 years in this case.

In a nutshell, the various accounting treatment for different securities are:

Class of Securities Types of Securities Disclosure on the Balance Sheet Treatment of Temporary changes in the value

Held to Maturity (HTM) Debt Amortized Cost Not Recognized

Available for Sale (AFS) Debt & Equity Fair Market Value (FMV) Reported in the Stockholders Equity

Trading Debt & Equity Fair Market Value (FMV) Reported on the Income Statement

Equity Method Equity Historical cost adjusted for changes in the net assets of the investee. Not Recognized

Trading securities and available-for-sale securities are intended to be sold if their price rises high enough which makes the FMV very important to the users of the financial statements. However, available-for-sale securities, are not expected to be sold in the current accounting period, which consequently makes the unrealized gains or losses reported through Accumulated Other Comprehensive Income (AOCI) recorded in the section of Stockholders’ Equity within the balance sheet instead of diverting into Retained Earnings of the income statement.

Conclusion-Held to Maturity Security Examples

It should be observed that though the Held to Maturity securities offer multiple accounting benefits to financial institutions, it substantially reduces liquidity within the bond portfolio. A later sale of the bond is precluded unless other similar issues are also reverted from HTM to AFS. On a regular basis, the sale of these securities can raise concerns with external accountants and examiners.