A day-count convention measures how interest accrues on investments like bonds, notes, mortgages, and loans over time. Specifically, it is a system used in the bond market to determine the number of days and the amount of accrued interest between two coupon dates (when the next coupon date is less than a full coupon period away).
The calculation is important to traders of various bonds because, when a bond is sold, the seller is entitled to a portion of the coupon payment. The day-count convention determines precisely how much.
- A day-count convention is used to calculate the number of days and the amount of accrued interest between two coupon dates.
- The calculation is important to bond traders because, when a bond is sold, the seller is entitled to some of the coupon payment.
- The 30/360 convention is the simplest, as it assumes that each month has 30 days.
- Actual/actual uses the precise number of days in the month and the year, ensuring that all bond traders are on an even playing field when a bond is sold in between two coupon dates.
Since there is no central authority to define day-count rules across all securities, there is no standard terminology to apply to all situations. However, the International Swap Dealers Association has gathered and documented common methods. The three to understand are conventions known as "30/360," "Actual/360," and "Actual/Actual."
The notation used for day-count conventions shows the number of days in any given month divided by the number of days in a year. The result represents the fraction of the year remaining that will be used to calculate the amount of interest owed.
The 30/360 notation is the easiest convention to use because it assumes that there are 30 days in every month, even though some months actually have 31 days. For example, the period from May 1 to August 1 is considered to be 90 days apart, according to the 30/360 convention, but the actual number of days is higher because both May and July have 31 days.
Given the simplicity of the 30/360 day-count convention, it is often used in calculations of accrued interest for corporate, agency, and municipal bonds. It is also commonly used by investors of mortgage-backed securities.
Actual/360 and Actual/365
Actual/360 is most commonly used when calculating the accrued interest for commercial paper, T-bills, and other short-term debt instruments that have less than one year to expiration. It is calculated by using the actual number of days between the two periods, divided by 360.
As you probably guessed, actual/365 is similar to the actual/360, except that it uses 365 as the denominator. Actual/365 is most commonly used when pricing U.S. government Treasury bonds.
Actual/actual convention uses the actual number of days between two periods and divides the result by the number of days in the year, rather than assuming that each year is made up of 360 or 365 days.
Of course, we know that in reality there are always 365 days in a year (with the exception of leap years), but these conventions are standards that have developed over time and help to ensure that everyone is on the same playing field when a bond is sold between coupon dates.