Definition / Meaning of Accrued interest
Accrued interest is the interest that has accumulated on a bond or other fixed-income security since the last interest payment date. When you buy or sell a bond between coupon payment dates, the buyer must pay the seller the accrued interest for the period the seller held the bond. This ensures that the seller receives the interest earned up to the sale date, and the buyer receives the full coupon payment on the next payment date.
How Does Accrued Interest Work?
Most bonds pay interest semi-annually (twice a year) at a fixed rate. Interest accrues daily between these payment dates. For example, if a bond pays a coupon on January 1 and July 1, and you sell it on March 1, the seller has held the bond for 59 days and is entitled to the interest earned during those days. At settlement, the buyer pays the seller the bond’s market price plus the accrued interest, which is calculated using a specific day-count convention (such as actual/actual).
Why Is Accrued Interest Important?
Accrued interest ensures the bond market operates fairly for both buyers and sellers. Without it, a seller who held a bond for nearly six months would receive no interest, while the new buyer would collect the full six-month payment—creating an unfair transfer of value. Accounting for accrued interest maintains the time value of money principle and keeps trading efficient.
Accrued Interest in Tax Reporting
For tax purposes, accrued interest is treated as interest income to the seller and as a capital cost to the buyer. If you buy a bond, the accrued interest you pay is added to your cost basis. When you later sell the bond or receive the next coupon, you report the interest income accordingly. This treatment aligns with accrual accounting principles, which record income and expenses when earned or incurred, not when cash changes hands.
Accrued Interest vs. Clean vs. Dirty Price
In bond markets, prices are often quoted as “clean” (without accrued interest) or “dirty” (including accrued interest). The clean price is the bond’s present value of future cash flows, excluding accrued interest. The dirty price is the actual amount you pay, which is the clean price plus accrued interest. This distinction is critical for comparing bond prices across different trading dates and for calculating the yield to maturity accurately.
Example of Accrued Interest
Suppose you own a $1,000 bond with a 6% annual coupon, paying $30 every six months. If the last payment was 60 days ago and you sell the bond today, the accrued interest is calculated as:
- Daily interest = $30 / 180 days (using a 180-day half-year) = $0.1667 per day
- Accrued interest = 60 days × $0.1667 = $10.00
So, the buyer pays you $10 in addition to the bond’s clean price.