Very simply, accrued interest income is a term that refers to interest income that an investor has earned and is entitled to have, but they have not received. This occurs because a bond will make its interest payments at set intervals, but the holder may decide to sell the bond in between the scheduled payment dates.
Note: A bond pays interest at set regular intervals, typically twice a year, based upon the bond’s original issue date. For example, if the bond was issued on December 31st, then it will typically pay the full year’s interest in two equal installments: one on December 31st and one on June 30th.
Issuers of bonds will make the interest payments to the registered holders on the interest payment dates. They do not keep track of the buying and selling of the bonds and who has earned interest by owning a bond. Therefore, the administrators of the secondary bond market calculate the interest income accruing on each bond purchase, between the bond’s interest payment dates.
When an investor sells a bond prior to the bond’s maturity date, they are entitled to all accrued interest income earned, but not paid, up to the settlement date of the sale. When purchasing a bond, the interest accruing to the seller is calculated from the last interest payment date, or their purchase date if after the interest payment date, to the seller’s settlement date.
Just like common and preferred shares, bond purchases and sales have a trade date and a settlement date. The trade dateis the actual date that the purchase or sale was completed or contracted. The dealers/administrators then must complete or settle the buy and sale on the third business day after the trade date. The settlement date is the third business day after the trade date.
The day-count conventionis a system used to determine the number of days between two coupon dates, which is important in calculating accrued interest and present value when the next coupon payment is less than a full coupon period away. Each bond market has its own day-count convention. There are several different types of day-count conventions. In Canada, bond accrued interest is calculated using an actual/365 day count convention. When the last calendar day in a month is not a business day, accrued interest is calculated to the last business day of the month.
The actual/365 day count convention considers a year to have 365 days, while the length of the coupon period is calculated by dividing 365 by the number of coupon periods in the year.
For U.S. Government bonds (called Treasuries), accrued interest is calculated using the same actual/365 day count convention.
For U.S Corporate bonds, a 30/360 day-count convention assumes there are 30 days in a month and 360 days in a year.
An actual/actual day-count convention uses the actual number of days in the month and year for a given interest period.
This concept might sound illogical. After all, regardless of the particular bond market there will always be 365 days in a year! Nevertheless, these conventions are standards that have developed over time and help to ensure that everybody is on an even playing field when a bond is sold between coupon dates.
Example: Let’s assume that our $100,000 par value bond, with a 4.375% coupon, matures in two years on March 3rd and is a Canadian issue. Let’s assume that the trade date was March 12th. This would make March 15th the settlement date. Therefore, the investor that sold this bond is entitled to the interest income earned on the bond from March 3rd to the settlement date of March 15th, or 12 days. The accrued interest income is calculated as follows:
Interest earned for a full year equals $4,375.00 ($100,000 multiplied by 4.375%). The $4,375.00 divided by 365 days equals $11.98630 per day, multiplied by 12 days equals $143.84 in accrued interest. So, by purchasing $100,000.00 par value at a price of $105.75 means that the purchaser would pay the seller $105,750.00 plus $143.84 of accrued interest.
If the new bond owner holds the bond on the next interest payment date of September 3rd, the issuer will pay the bondholder the full six months of interest income or $2,187.50. This represents reimbursement of the $143.84 in accrued interest paid plus the interest earned for holding the bond from March 15th to September 3rd.
Note:When a bond investor prepares their annual income tax return the full bond interest income will be reported in the investor’s T5 Income Tax Information Slip as Interest Income. The accrued interest paid will be listed in the Summary of Investment Income – Dividends and Interest (not the T-5 Slip), as an Interest Expense and should be deducted from the investor’s interest income. Investors should consult with their income tax advisor.