Accrued interest is the interest that has accumulated on a bond or other fixed-income security since the exact date of the last interest payment was made.
Calculating bond interest between payments
Fixed-income securities like bonds pay interest to investors on a set schedule. This schedule is typically semi-annual or annual. Between these scheduled payment dates, the interest accrues daily. When Elephants buy or sell a bond in the secondary market between payment dates, the transaction must account for the interest that has accumulated since the issuer last distributed cash to bondholders.
The seller of the bond earned interest for the specific days they held the security. The buyer compensates the seller for this accumulated amount at the time of the trade. Financial markets differentiate between the clean price and the dirty price to manage this transfer. The clean price is the market value of the bond itself. The dirty price is the clean price plus the accrued interest. Buyers pay the dirty price to acquire the bond.
Markets across the world use specific day-count conventions to calculate the exact amount of accrued interest. Government bonds often use an actual/actual convention, which counts the precise number of days in the month and the year. Corporate bonds frequently rely on a 30/360 convention, assuming standardized 30-day months and a 360-day year. The calculation multiplies the daily interest rate by the number of days the seller held the bond since the previous payment date.
Example
Suppose an Elephant investor holds a corporate bond with a face value of 10,000 currency units and an annual coupon rate of 6 percent. The bond issuer pays interest semi-annually on January 1 and July 1. Each full payment is 300 currency units. The Elephant sells the bond to another investor on April 1. Exactly 90 days have passed since the January 1 payment. The seller is entitled to the interest generated over those 90 days, which amounts to 150 currency units. The buyer pays the agreed market price of the bond plus the 150 units of accrued interest. On July 1, the new bondholder receives the full 300-unit payment from the issuer. This distribution covers the interest the new owner earned from April 1 to July 1 and reimburses the accrued interest paid to the original Elephant investor at the time of the sale.