accrued_interest

Accrued Interest

Accrued interest is the interest that has been earned on a loan or Bond, but has not yet been paid out. Think of it like a running tab. For bondholders, this is the amount of interest the bond has accumulated since its last Coupon payment date. When a bond is sold between these payment dates, the buyer must pay the seller not just the bond's market price, but also this “accrued” portion of the upcoming interest payment. This ensures fairness, as the seller is compensated for the time they held the bond and earned that interest. This concept is fundamental to the bond market because it allows these securities to be traded any day of the year, not just on the days when interest is paid. The buyer, in turn, will receive the full next coupon payment from the bond's issuer, which includes the amount they just paid to the seller, plus the interest earned from the day they bought it.

The mechanism behind accrued interest is all about splitting the coupon payment fairly between the old owner and the new one. This is reflected in how bonds are priced for a trade.

When you look up a bond's price on a financial website, you are almost always seeing its Clean Price. This is the price of the bond itself, without any accumulated interest. It's “clean” because it doesn't get distorted by the daily accumulation of interest, making it easier to compare the underlying value of different bonds. However, the price you actually pay or receive is the Dirty Price (also called the full or invoice price). This is the true cash amount that changes hands. It's calculated quite simply: Dirty Price = Clean Price + Accrued Interest This distinction is crucial. An investor who only looks at the clean price will get a surprise when they see the final bill for their purchase.

Let's break it down with some numbers. Imagine you want to buy a corporate bond with the following features:

  • Face Value: $1,000
  • Coupon Rate: 5% per year
  • Payment Schedule: Semi-annually, on January 1st and July 1st.

This means the bond pays out interest twice a year. The total annual interest is $1,000 x 5% = $50. Since it's paid semi-annually, each payment is $25. Now, let's say the previous owner, Sarah, decides to sell this bond to you on April 1st. The last interest payment was on January 1st. Three months (roughly 90 days) have passed since then. Sarah has held the bond for half of the six-month interest period, so she is entitled to half of the next $25 payment.

  • Interest earned per day: $25 / 182.5 days (half a year) ≈ $0.137 per day.
  • Accrued interest for 90 days: 90 days x $0.137/day ≈ $12.33.

If the bond's clean price on April 1st is $990, you don't just pay $990. You will pay the dirty price: $990 (Clean Price) + $12.33 (Accrued Interest) = $1,002.33 You pay Sarah $1,002.33. Then, on July 1st, the company that issued the bond will pay you the full $25 coupon. You get to keep the half you earned ($12.67) and are essentially reimbursed for the $12.33 you paid to Sarah. Everyone is compensated fairly.

For a Value Investing practitioner, understanding the true cost and return of any asset is non-negotiable. Accrued interest is a key piece of that puzzle.

First and foremost, a value investor should recognize that paying accrued interest is not “losing” money, and receiving it is not a “bonus.” It's a simple, elegant mechanism for ensuring the seller of a Debt Security gets what they are owed. It prevents investors from gaming the system by, for example, buying a bond the day before a coupon payment just to capture the full amount without having held the risk for the entire period.

Knowing the dirty price is essential for accurately calculating your investment's true return. If you only used the clean price in your calculations, you would miscalculate your cost basis. This, in turn, would lead to an incorrect figure for the bond's Yield to Maturity (YTM), which is the total return an investor can expect if they hold the bond until it matures. A value investor relies on precise calculations to determine if an asset meets their criteria for a margin of safety, and getting the initial cost wrong throws everything else off.

The way accrued interest is handled has tax consequences. For the seller, the accrued interest they receive from the buyer is generally treated as ordinary income and is taxable. For the buyer, when they later receive the full coupon payment, the portion that was the accrued interest they already paid can often be used to reduce their taxable interest income. While tax laws differ between the U.S. and Europe, the principle remains: accrued interest is treated differently from a capital gain. A savvy investor always keeps the tax implications in mind when evaluating the total return of an investment.