Legal Definitions - income-basis method

The income-basis method is a way to calculate the actual financial return an investor receives from a security, such as a bond or preferred stock. Instead of using the security's original or stated 'face value' (the amount it's officially worth or will pay back at maturity), this method focuses on the actual price the investor paid for the security and the income (like interest or dividends) they regularly receive from it. This provides a more realistic measure of profitability relative to the investor's true outlay.

• Example 1: Buying a Bond at a Discount
  An investor purchases a corporate bond with a face value of $1,000. This bond pays $50 in interest annually. However, because market interest rates have risen since the bond was issued, the investor is able to purchase this bond on the open market for only $900.

  How it illustrates the term: Using the income-basis method, the investor would calculate their rate of return based on the $900 they actually paid for the bond, not its $1,000 face value. They would then compare the $50 annual interest income to their $900 investment to determine their true yield, which would be higher than if calculated against the face value.

• Example 2: Investing in Preferred Stock
  A company issues preferred stock with a par value (similar to face value) of $100 per share, paying a fixed annual dividend of $6 per share. An investor purchases 100 shares of this preferred stock on the stock market for $95 per share, totaling $9,500.

  How it illustrates the term: The income-basis method would calculate the investor's return based on the $9,500 they paid for the shares, not the $10,000 total par value (100 shares x $100 par). The $600 in annual dividends (100 shares x $6) would then be measured against the $9,500 actual investment to determine the true dividend yield, giving a more accurate picture of the return on their specific investment.

• Example 3: Buying a Bond at a Premium
  Another investor purchases a government bond with a face value of $1,000 that pays $70 in interest annually. Because this bond offers a higher interest rate than currently available in the market, the investor has to pay a premium, purchasing it for $1,050.

  How it illustrates the term: The income-basis method would compute the rate of return using the $1,050 actual price paid by the investor, rather than the bond's $1,000 face value. The $70 annual interest income would then be compared to the $1,050 investment. This calculation is crucial because it shows that while the bond pays $70, the return on the actual money invested is lower due to the premium paid, providing a more realistic yield than simply dividing $70 by the $1,000 face value.