Held to maturity

What Is Held to Maturity?

Held to maturity (HTM) is an Financial Accounting classification for certain debt securities that an entity has the positive intent and ability to hold until their contractual maturity date. This classification dictates how these investments are reported on a company's balance sheet and impacts the recognition of unrealized gains and losses. Unlike trading securities or available-for-sale securities, held to maturity investments are generally recorded at amortized cost rather than fair value. This means that fluctuations in market value due to changing interest rates are not immediately recognized in the company's income statement or other comprehensive income.

History and Origin

The accounting standards for investment securities in the United States have evolved significantly, particularly in response to financial crises. The current framework for held to maturity securities and other investment classifications largely stems from Accounting Standards Codification (ASC) 320, which has its roots in Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," issued by the Financial Accounting Standards Board (FASB) in 1993. This standard was developed in the aftermath of the savings and loan crisis of the 1980s, where concerns arose about financial institutions' ability to accurately reflect the economic reality of their debt securities portfolios.¹⁴ At the time of its adoption, many banks advocated for the use of amortized cost for debt securities, arguing that it more accurately reflected their long-term earning effects and ultimate recoverable value when the intent was to hold them to maturity.¹³ The Securities and Exchange Commission (SEC) delegated the authority for creating accounting standards to private organizations, eventually leading to the FASB as the primary standard-setter for U.S. Generally Accepted Accounting Principles (GAAP).¹²

Key Takeaways

• Held to maturity (HTM) is an accounting classification for debt securities that a company intends and has the ability to hold until their maturity date.
• HTM securities are reported on the balance sheet at amortized cost, meaning changes in their fair value are not typically recognized in earnings or other comprehensive income.
• This classification differs from trading securities and available-for-sale securities, which are generally marked to fair value.
• The rigorous criteria for HTM classification aim to prevent companies from selectively recognizing gains or avoiding losses.
• Recent banking sector instability has prompted renewed debate about the transparency provided by HTM accounting, especially regarding unrealized losses.

Formula and Calculation

Held to maturity securities are measured at their amortized cost. This involves adjusting the initial cost of the security for any premiums or discounts paid at acquisition over the life of the instrument using the effective interest method.

The amortized cost at a given period can be calculated as follows:

Where:

• (\text{Amortized Cost}_{\text{beginning}}) is the carrying value of the security at the start of the period.
• (\text{Interest Income}) is calculated based on the effective interest rate applied to the beginning amortized cost.
• (\text{Cash Received}) is the stated coupon payment received during the period.

Premiums are amortized as a reduction of interest income, while discounts are amortized as an addition to interest income, ensuring the security reaches its face value at maturity.¹¹

Interpreting the Held to Maturity

The classification of an investment as held to maturity signifies a company's long-term investment strategy. When a company holds a debt security with the intent and ability to collect its contractual cash flows until maturity, the principal financial statement implication is that temporary fluctuations in the security's market price are disregarded for reporting purposes. Instead, the focus remains on the expected stream of interest payments and the repayment of principal at maturity. This approach provides a stable carrying value on the balance sheet that reflects the original investment decision and the predictable cash flows, rather than market volatility. Analysts interpreting financial statements must be aware that the reported amortized cost of held to maturity securities may differ significantly from their current market fair value, particularly in environments of rapidly changing interest rates. This difference, though disclosed in footnotes, does not impact the reported carrying amount or net income.

Hypothetical Example

Suppose ABC Bank purchases a corporate bond with a face value of $1,000, a 5% annual coupon rate, and a 10-year maturity. The bank acquires the bond for $950, effectively purchasing it at a discount, and classifies it as held to maturity because it fully intends and has the ability to hold it until the maturity date.

Year 1:

• Initial Purchase Price: $950
• Face Value: $1,000
• Discount: $50 ($1,000 - $950)
• Stated Interest (Coupon): $50 (5% of $1,000)

Using the effective interest method, let's assume the effective interest rate is 5.75% (this rate would discount the bond's future cash flows back to $950).

• Interest Income (Year 1): $950 (Amortized Cost) * 5.75% = $54.63
• Cash Received (Coupon Payment): $50
• Amortization of Discount: $54.63 (Interest Income) - $50 (Cash Received) = $4.63
• Amortized Cost (End of Year 1): $950 + $4.63 = $954.63

ABC Bank will report this bond at an amortized cost of $954.63 on its balance sheet at the end of Year 1, and $54.63 as interest income on its income statement. The bond's market value might fluctuate throughout the year, but these changes are not reflected in the reported figures as long as the bond remains classified as held to maturity.

Practical Applications

The held to maturity classification is crucial in the accounting and financial reporting for various entities, particularly financial institutions like banks and insurance companies that manage large portfolios of fixed-income instruments. Common examples of held to maturity securities include Treasury bonds, corporate bonds, and municipal bonds that are expected to be held until their maturity date. This classification impacts regulatory capital calculations and how an institution's financial health is perceived.

For instance, banks utilize this classification as part of their asset-liability management strategies, aiming to match the duration of their assets with their liabilities. By holding certain investments to maturity, they seek to ensure a predictable stream of cash flows to meet future obligations.¹⁰ While the amortized cost accounting for held to maturity securities provides stability to reported earnings and capital, the unrealized losses or gains on these portfolios are typically disclosed in the footnotes to the financial statements.⁹ This disclosure is critical for investors and analysts to understand the potential exposure to interest rate risk that might not be immediately evident from the primary balance sheet. The recent failures of some regional banks in 2023, such as Silicon Valley Bank, highlighted how significant unrealized losses on held to maturity portfolios, although footnoted, could contribute to liquidity crises if the banks were forced to sell these "underwater" assets.⁸,⁷

Limitations and Criticisms

Despite its intended purpose of reflecting an entity's long-term investment strategy, the held to maturity (HTM) accounting classification faces significant limitations and has drawn considerable criticism, particularly in periods of volatile interest rates. A primary critique is that by reporting these securities at amortized cost rather than fair value, the classification can obscure the true economic condition and exposure to interest rate risk and liquidity risk that a company faces.⁶

The unrealized unrealized gains and losses on held to maturity portfolios are not recognized in the income statement or comprehensive income, instead appearing primarily in the footnotes to the financial statements.⁵ Critics argue that this "hidden in plain sight" approach makes it difficult for investors and depositors to assess the full extent of a firm's financial vulnerabilities, especially when market values decline significantly.⁴ The failures of several banks in early 2023 brought this issue to the forefront, as these institutions had substantial unrealized losses on their HTM securities due to rising interest rates, which were not reflected in their reported capital.³ Some investor advocates and academics have called for the elimination of the held to maturity classification, advocating for all financial instruments to be marked to fair value to provide more transparent and relevant information.²

However, proponents of HTM accounting argue that fair value accounting can introduce excessive volatility into financial statements, especially for assets that an entity truly intends to hold until maturity, as temporary market fluctuations do not affect the ultimate cash flows. They assert that for financial instruments held for collection, amortized cost provides a more relevant picture of the long-term earning effects and recoverable value.¹

Held to Maturity vs. Available-for-Sale Securities

The distinction between held to maturity (HTM) and available-for-sale securities (AFS) lies primarily in management's intent and the subsequent accounting treatment. Held to maturity securities are debt securities that a company has the positive intent and ability to hold until their contractual maturity date. As a result, they are recorded at amortized cost on the balance sheet, and unrealized gains and losses due to changes in fair value are not recognized in earnings or other comprehensive income. In contrast, available-for-sale securities are debt or equity securities not classified as held to maturity or trading. While also reported at fair value on the balance sheet, unrealized gains and losses on AFS securities are recognized in a separate component of shareholders' equity, known as accumulated other comprehensive income (AOCI), rather than directly impacting net income. This classification is used for investments that may be sold before maturity, but are not intended for active trading. The key confusion often arises because both categories involve holdings that are not for immediate resale, but the strict intent criteria for held to maturity means its fair value fluctuations bypass the income statement and comprehensive income entirely, a distinction that has significant implications for reported earnings and capital.

FAQs

What types of securities can be classified as held to maturity?

Only debt securities can be classified as held to maturity. This includes instruments like Treasury bonds, corporate bonds, and municipal bonds, provided the company has the genuine intent and ability to hold them until their maturity date. Equity securities cannot be classified as held to maturity.

How does held to maturity accounting differ from fair value accounting?

Held to maturity accounting uses amortized cost, meaning the asset's value on the balance sheet is adjusted only for premiums or discounts over its life, and market fluctuations are generally ignored. Fair value accounting, conversely, reports the asset at its current market price, and changes in that price are reflected in the company's financial statements (either in net income for trading securities or in other comprehensive income for available-for-sale securities).

Can a held to maturity security ever be sold before maturity?

Generally, no. The "held to maturity" classification requires a strong positive intent and ability to hold the security until its maturity. Selling a held to maturity security before its maturity, except in very rare circumstances (such as a significant deterioration in the issuer's credit risk), can "taint" a company's entire held to maturity portfolio. This tainting event could require reclassifying the remaining held to maturity securities into the available-for-sale category, which would then require them to be reported at fair value.