Do You Pay Accrued Interest When Purchasing Bonds?

Accrued interest is the interest that builds up on a bond between its regular coupon payment dates. When a bond is sold on the secondary market, the buyer must pay the seller this accrued interest to compensate them for the time they held the bond since the last payment. This ensures fairness in pricing, as the seller receives credit for the interest earned before the sale.

Learn more about accrued interest on bonds and why it’s important, as well as the mechanics of buying bonds.

Grasping Accrued Interest in Bond Deals

A bond represents a debt obligation whereby the owner (the lender) receives compensation in the form of interest payments. These interest payments, known as coupons, are typically paid every six months.

Ownership of bonds can be freely transferred between investors. However, a problem can arise over the issue of the ownership of interest payments. Only the owner of record can receive the coupon payment, but the investor who sold the bond must be compensated for the period of time for which they owned the bond. In other words, the previous owner must be paid the interest that accrued before the sale.

The interest paid on a bond is compensation for the money lent to the borrower, or issuer, and this borrowed money is referred to as the principal. The principal amount is paid back to the bondholder at maturity. Similar to the case of the coupon or interest payment, whoever is the rightful owner of the bond at the time of maturity will receive the principal amount. If the bond is sold before maturity in the market, the seller will receive the bond’s market value.

The accrued interest adjustment is thus the extra amount of interest that is paid to the former owner of a bond or other fixed-income security. The amount paid is equal to the balance of interest that has accrued since the last payment date of the bond.

Example of Accrued Interest Payment in Bonds

For example, assume a bond has a fixed coupon that is to be paid semiannually on June 1 and Dec. 1 every year. If a bondholder sells this bond on Oct. 1, the buyer receives the full coupon payment on the next coupon date scheduled for Dec. 1. In this case, the buyer must pay the seller the interest accrued from June 1 to Oct. 1. Generally, the price of a bond includes the accrued interest; this price is called the full or dirty price.

Accrued Interest in Convertible Bonds: An Overview

A convertible bond has an embedded option that gives a bondholder the right to convert their bond into the equity of the issuing company or a subsidiary. An interest-paying convertible bond will make coupon payments to bondholders for the duration of time that the bond is held.

After the bond has been converted to shares of the issuer, the bondholder stops receiving interest payments. At the time an investor converts a convertible bond, there will usually be one last partial payment made to the bondholder to cover the amount that has accrued since the last payment date of record.

Example of Accrued Interest Payment in Convertible Bonds

For example, assume interest on a bond is scheduled to be paid on March 1 and Sept. 1 every year. If an investor converts his bond holdings to equity on July 1, he will be paid the interest that has accumulated from March 1 to July 1. This final interest payment is the accrued interest adjustment.

Calculating Accrued Interest on Bonds with a Practical Example

Suppose investor A purchases a bond in the primary market with a face value of $1,000 and a coupon of 5% paid semiannually. After 90 days, investor A decides to sell the bond to investor B. The amount investor B has to pay is the current price of the bond plus accrued interest, which is simply the regular payment adjusted for the time investor A held the bond.

In this case, the bond would be $50 over the entire year ($1,000 × 5%), and investor A held the bond for 90 days, which is a quarter of the recorded year, or 25% (calculated by 90/360). So, the accrued interest ends up being $12.50 ($50 × 25%). So investor B will have to pay investor A the value of the bond in the market, plus $12.50 of accrued interest.

The Bottom Line

Accrued interest accumulates over time on a debt, such as a bond or loan, but hasn’t yet been paid out. Because bond interest is typically paid on a set schedule, buyers who purchase a bond between payment dates must pay the seller the accrued interest since the last payment. This ensures that they are fairly compensated for the interest earned before the transfer of ownership.