You need to know that there are two conflicting conventions concerning the number of days of accrued interest in a year:
- Corporate and municipal bonds use 360 days
- Government bonds tend to use 365 days.
- T-bills, as you have seen, are the exception. For the purposes of the Series 7 exam, you will likely be told which convention to use in a calculation. For real-life purposes, it is important that you know which one to use because it determines how much accrued interest the bond has accumulated but not yet received in a cash payment.
When a bondholder has earned but not received an interest payment, the bond is said to be trading "and interest". That means that the amount of accrued interest will be added to the sale price if the owner sells the security.
To compute how much accrued interest is attached to a bond, follow these steps:
- Divide the number of days in the elapsed period by the number of days in a year to come up with the fraction of the year. Let's assume you are dealing with a corporate bond that follows the 360-day year convention and makes semi-annual interest payments, and it is 80 days until the next scheduled coupon date. So, you divide 100 days by 360 days, and your result is 0.277778. This is the fraction of the year.
- Multiply the fraction of the year by the principal. Assuming your principal is $1,000, your result will be $277.78 (0.277778 times $1,000).
- Multiply the result of step 2 by the interest rate. Assuming the rate is 7%, your final result is $19.44 ($277.78 times 0.07).
Thus, $19.44 in accrued interest needs to be added to the price of this bond before it is sold in order to ensure the current owner receives all due benefits from holding the bond up to this point.
The detailed tutorial Advanced Bond Concepts explains some of the more complex concepts and calculations you need to know for trading bonds, including bond pricing, yield, term structure of interest rates, duration, and much more.
InvestingBonds offer undeniable benefits to investors, including safety and tax advantages.
InvestingBond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
InvestingLearn these basic terms to breakdown this seemingly complex investment area.
InvestingUnderstanding this relationship can help an investor in any market.
InvestingLearn about three major signals that you should sell your bonds right now, including impending interest rate hikes and bond issuer instability.
InvestingDon't assume that you can't lose money in this market - you can. Find out how.
InvestingMunicipal bonds and bond funds differ in several ways, which is partly why they complement each other well.