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.
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