DEFINITION of 'Accrued Interest Adjustment'

Accrued interest adjustment is the extra amount of interest that is paid to the owner of a convertible bond or other fixed income security. The amount paid is equal to the balance of interest that has accrued since the last payment date of the bond.

BREAKING DOWN 'Accrued Interest Adjustment'

A convertible bond has an embedded option which gives a bondholder the right to convert his or her bond into equity of the issuing company or a subsidiary. An interest-paying convertible bond will make coupon payments to bondholders for the duration of time the bond is held. After the bond has been converted to shares of the issuer, the bondholder stops receiving interest payments. At the time an investor converts a convertible bond, there will usually be one last partial payment made to the bondholder to cover the amount that has accrued since the last payment date of record. For example, assume interest on a bond is scheduled to be paid on March 1and September 1 every year. If an investor converts his bond holdings to equity on July 1, he will be paid the interest that has accumulated from March 1 to July 1. This final interest payment is the accrued interest adjustment.

Also, when buying bonds in the secondary market, the buyer will have to pay accrued interest to the seller as part of the total purchase price. An investor that purchases a bond sometime between the last coupon payment and the next coupon payment will receive the full interest on the scheduled coupon payment date given that s/he will be the bondholder of record. However, since the buyer did not earn all of the interest accrued over this period, s/he must pay the bond seller the portion of interest that the seller earned before selling the bond. For example, assume a bond has a fixed coupon that is to be paid semi-annually on June 1 and December 1 every year. If a bondholder sells this bond on October 1, the buyer receives the full coupon payment on the next coupon date scheduled for December 1. In this case, the buyer must pay the seller the interest accrued from June 1 to October 1. Generally, the price of a bond includes the accrued interest; this price is called the full or dirty price.

The accrued interest adjustment decreases the taxable interest income by deducting the extra amount of interest that is paid to the owner of a fixed income security. The accrued interest adjustment is always taxable as ordinary interest. The amount of the accrued interest adjustment will always vary, according to the number of days that elapse between the last payment date of record and the date of conversion.

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