A:

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. During this period the ownership of the bonds can be freely transferred between investors. A problem then arises 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 he or she 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, this borrowed money is referred to as the principal. The principal amount is paid back to the bondholder at maturity. Similar with 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.

For example, suppose investor A purchases a bond in the primary market with a face value of $1,000 and a coupon of 5% paid semi-annually. 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 x 5%), and investor A held the bond for 90 days which is almost a quarter of the year, or 24.66% to be exact (calculated by 90/365). So, the accrued interest ends up being $12.33 ($50 x 24.66%). So investor B will have to pay investor A the value of the bond in the market, plus $12.33 of accrued interest.

For more in-depth reading, see our tutorial on Bond Basics, as well as the chapter Bond Pricing in our Advanced Bond Tutorial.)

RELATED FAQS
  1. How do you find accrued interest on a bond?

    A bond is a debt instrument issued by a company, government agency or municipality to raise money. Interest payments are ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>
  4. How do I use the holding period return yield to evaluate my bond portfolio?

    The holding period return yield formula can be used to compare the yields of different bonds in your portfolio over a given ... Read Full Answer >>
  5. What is the relationship between current yield and yield to maturity (YTM)?

    Both the current yield and yield to maturity (YTM) formulas are methods of calculating the yield of a bond. However, these ... Read Full Answer >>
  6. What is a 'busted' convertible bond?

    In finance, a convertible bond represents a hybrid security that offers debt and equity features and risks. While a convertible ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  3. Mutual Funds & ETFs

    ETF Analysis: Guggenheim BulletShrs 2018 HY CorpBd

    Find out about the Guggenheim BulletShares 2018 High Yield Corporate Bond ETF, and get information about this ETF that focuses on high-yield corporate bonds.
  4. Mutual Funds & ETFs

    ETF Analysis: First Trust Tactical High Yield

    Find out more about the First Trust Tactical High Yield fund, a debt security-focused ETF designed to produce high income.
  5. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Short Term Hi Yld Bd

    Find out about the SPDR Barclays Short Term High Yield Bond ETF, and explore detailed analysis of the fund that tracks short-term, high-yield corporate bonds.
  6. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Bond

    Find out about the Vanguard Intermediate-Term Bond ETF, and delve into detailed analysis of this fund that invests in investment-grade intermediate-term bonds.
  7. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Short Term Corp Bd

    Learn about the SPDR Barclays Short-Term Corporate Bond ETF, and explore detailed analysis of the exchange-traded fund tracking U.S. short-term corporate bonds.
  8. Investing Basics

    What to Cut From Your Portfolio Right Now

    Owning stocks may shortly become too scary for your portfolio. Here's why, and here are some alternatives.
  9. Professionals

    Top 4 Ways to Avoid Muni Bond Mistakes

    Muni bonds are often perceived as safe investments. But it's important to do some thorough research before investing.
  10. Investing

    6 Reasons Why Every Investor Should Consider ETFs

    Once you understand the benefits of ETFs, you’ll see how they could be an exciting and smart way to help meet your financial goals. Here some key facts.
RELATED TERMS
  1. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  2. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  3. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
  4. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  5. Accelerated Return Note (ARN)

    A short- to medium-term debt instrument that offers a potentially ...
  6. Next Generation Fixed Income (NGFI) Manager

    A Next Generation Fixed Income (NGFI) manager is a fixed income ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!