What is accrued interest, and why do I have to pay it when I buy a bond?

By Investopedia Staff AAA
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. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ...
  2. How long will it take for a bond to reach its face value?

    Learn when different savings bonds reach face value, and determine the best time to cash them in to get the highest return ...
  3. How long can I hold my HH/H Bonds and still earn interest?

    Take advantage of your bond investment and learn how long you can hold on to your Series H/HH Bonds and still earn interest ...
  4. Why should I keep records on my tax-exempt bond transactions?

    Keep your purchase records on all investments, including tax-exempt bonds. Though the interest is tax-free, you may owe taxes ...
RELATED TERMS
  1. Class 3-6 Bonds

    Several classes of noninvestment grade bonds held by an insurance ...
  2. Impact investing

  3. Promotional CD rate (Bonus CD rate)

    A limited-time offer of a higher rate of return on a certificate ...
  4. Direct Bidder

    An entity that purchases Treasury securities at auction for a ...
  5. Indirect Bidder

    An entity that purchases Treasury securities at auction through ...
  6. Bid Wanted

    An announcement by an investor who holds a security that he or ...

You May Also Like

Related Articles
  1. Promising high yields that the Eurozone and U.S. can't match, West African sovereign debt has caught the attention of savvy investors.
    Bonds & Fixed Income

    Interested In West African Debt? Look ...

  2. Pimco has stabilized its Total Return fund, but its returns are still shaky and its sales load is still a fat one.
    Professionals

    A Look At Pimco's Total Return Fund ...

  3. With the addition of 'Bond King' Bill Gross, Janus is a changed firm. Here's what its fund lineup looks like now.
    Investing Basics

    How Does Janus's Fund Lineup Look Now?

  4. Blackrock has lowered its fees to snag money leaving Pimco's bond funds. But by how much and who's following suit? Read on.
    Investing Basics

    Thank You, Pimco: BlackRock Drops Bond-Fund ...

  5. What is the difference between corporate bonds and preferred stock? The following are a list of pros and cons for each investment.
    Trading Strategies

    Preferred Stocks versus Bonds: How to ...

Trading Center