Accrued interest refers to the amount of interest that has accumulated on a bond since its last interest payment date. When a bond is traded between investors, the buyer typically pays the seller the market price of the bond, plus any accrued interest that has built up until the transaction date.
Bonds typically pay interest to bondholders periodically, such as semiannually or annually. The interest payment is based on the bond’s coupon rate and its face value. However, between interest payment dates, if a bond is bought or sold, the buyer will owe the seller the proportionate amount of interest that has accrued up to the transaction date.
To calculate accrued interest, you need to know the bond’s coupon rate, its face value, the last interest payment date, and the settlement date (the date on which the bond is bought or sold).
Here’s how to calculate accrued interest:
Determine the time period: Calculate the number of days that have passed between the last interest payment date and the settlement date.
Calculate the daily interest: Divide the bond’s annual coupon payment by the number of days in a year to find the daily interest. For example, if the bond has a Rs. 1,000 face value and a 5% coupon rate, the annual coupon payment would be Rs. 50. If there are 365 days in a year, the daily interest would be Rs. 50 divided by 365.
Multiply the daily interest by the number of days accrued: Multiply the daily interest by the number of days that have passed since the last interest payment date to the settlement date. This will give you the accrued interest amount.
For example, if 30 days have passed since the last interest payment date, and the daily interest is Rs. 50/365, then the accrued interest would be (Rs. 50/365) multiplied by 30.
Accrued interest is typically added to the bond’s purchase price, and the buyer reimburses the seller for the accrued interest. The buyer will then receive the full interest payment at the next scheduled interest payment date.
Accrued interest is an important consideration when buying or selling bonds because it ensures that both the buyer and seller receive the appropriate amount of interest based on the time they hold the bond. It ensures a fair distribution of interest payments between the parties involved in the bond transaction.