What Is Accrued Interest Adjustment?

Accrued interest adjustment lowers a fixed-income security buyer's taxable interest income by reducing the extra interest amount that is paid to them.

Key Takeaways

  • Accrued interest adjustment lowers a fixed-income security buyer's taxable interest income by reducing the extra interest amount that is paid to them.
  • Accrued interest adjustment is subject to the same laws of taxation as is ordinary interest.
  • Accrued interest adjustment amount will vary based on the number of days that elapse between the last payment date of record and the date of conversion.

Understanding Accrued Interest Adjustment

A convertible bond has an embedded option which gives a bondholder the right to convert their bond into the 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. Accrued interest is the total interest that has been amassed since the last coupon payment date and is the amount that is owed to the owner of a convertible bond or other fixed-income security.

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 1st and September 1st every year. If an investor converts their bond holdings to equity on July 1st, they will be paid the interest that has accumulated from March 1st to July 1st.

When buying bonds in the secondary market, the buyer will, usually, 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 they will be the bondholder of record. This final interest payment is the accrued interest.

However, since the buyer did not earn all of the interest accrued over this period, they must pay the bond seller the portion of the 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 1st and December 1st every year. If a bondholder sells this bond on October 1st, the buyer receives the full coupon payment on the next coupon date, which would be December 1st. In this case, the buyer must pay the seller the interest accrued from June 1st to October 1st. Generally, the price of a bond includes the accrued interest and 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 new owner of the fixed income security. The accrued interest adjustment is subject to the same laws of taxation as is 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.