Accrued Interest

Definition

Accrued interest is the interest that has accumulated on a bond or loan since the last interest payment was made but has not yet been paid to the investor or lender. This concept is particularly important in bond markets where interest payments are typically made on a semiannual basis, and it plays a crucial role in determining the price of a bond when it is bought or sold between payment dates.

5 Must Know Facts For Your Next Test

1. Accrued interest is calculated based on the number of days since the last coupon payment, making it essential for investors when trading bonds.
2. When purchasing a bond, investors often pay the dirty price, which includes accrued interest in addition to the clean price.
3. If a bondholder sells their bond before the next coupon payment, the buyer must compensate them for the accrued interest up to that date.
4. In financial statements, accrued interest is typically recorded as a liability for borrowers and an asset for lenders or investors.
5. Understanding accrued interest helps investors evaluate the true cost of purchasing bonds and make informed investment decisions.

Review Questions

• How does accrued interest impact the pricing of bonds when they are bought or sold in secondary markets?
  • Accrued interest affects bond pricing by adding to the overall cost when a bond is bought or sold in secondary markets. When an investor purchases a bond between coupon payment dates, they need to pay not only the clean price but also the accrued interest that has built up since the last coupon payment. This means that sellers can recoup some of their lost interest income while buyers must consider this additional cost when evaluating their investment.
• Discuss how accrued interest can influence an investor's decision-making process in bond investments.
  • Investors need to factor in accrued interest when deciding whether to buy or sell bonds. If an investor is looking to sell a bond shortly before a coupon payment, understanding accrued interest is crucial, as they will receive less than if they waited for the payment. Conversely, buyers may find value in purchasing bonds with significant accrued interest if they believe future market conditions will be favorable, ultimately affecting their yield to maturity calculations and overall investment strategy.
• Evaluate how knowledge of accrued interest can enhance an investor's ability to manage risk in their fixed-income portfolio.
  • Having a solid understanding of accrued interest enables investors to better manage risk within their fixed-income portfolios by allowing them to anticipate cash flow needs and market conditions. For instance, by calculating accrued interest accurately, investors can assess whether selling a bond before its coupon date would be beneficial or detrimental based on potential price fluctuations. Additionally, this knowledge helps them navigate tax implications related to interest income, allowing for more strategic financial planning and investment decisions that align with their risk tolerance.

Related terms

Coupon Rate: The annual interest rate paid on a bond, expressed as a percentage of the bond's face value.

Yield to Maturity: The total return anticipated on a bond if it is held until it matures, taking into account all interest payments and the difference between the purchase price and par value.

Dirty Price: The price of a bond that includes both the accrued interest and the clean price, which is the price excluding accrued interest.