Accrued interest is the amount of interest that has been earned on a debt but that has not yet been collected.Interest accumulates from the date a loan is issued or when a bond's coupon is made, but payments may only be made every six months.
When buying bonds in the secondary market, the buyer may have to payaccrued interestto the seller as part of the total purchase price.
Key Takeaways
- Accrued interest is the amount of interest earned on a debt, such as a bond, but not yet collected.
- Interest accumulates from the date a loan is issued or when a bond's coupon is made, but coupon payments are only paid twice a year.
- The accrued interest adjustment on a bond is the amount paid, which is equal to the balance of interest that has accrued since the last payment date of the bond.
Accrued Interest and the Bond Market
A bond represents a debt obligation whereby the owner (the lender) receives compensation in the form of interest payments. These interest payments, known as coupons, are typically paid every six months.
Ownership of bonds can be freely transferred between investors. However, a problem can arise over the issue of the ownership of interest payments. Only the owner of record can receive the coupon payment, but the investor who sold the bond must be compensated for the period of time for which they owned the bond. In other words, the previous owner must be paid the interest that accrued before the sale.
The interest paid on a bond is compensation for the money lent to the borrower, or issuer, and this borrowed money is referred to as the principal. The principal amount is paid back to the bondholder at maturity. Similar to the case of the coupon, or interest payment, whoever is the rightful owner of the bond at the time of maturity will receive the principal amount. If the bond is sold before maturity in the market the seller will receive the bond's market value.
The accrued interest adjustment is thus the extra amount of interest that is paid to the former owner of a bond or other fixed-income security. The amount paid is equal to the balance of interest that has accrued since the last payment date of the bond.
Example
For example, assume a bond has a fixed coupon that is to be paid semi-annually on June 1 and December 1 every year. If a bondholder sells this bond on October 1, the buyer receives the full coupon payment on the next coupon date scheduled for December 1. In this case, the buyer must pay the seller the interest accrued from June 1 to October 1. Generally, the price of a bond includes the accrued interest; this price is called the full ordirty price.
Accrued Interest and Convertible Bonds
Aconvertible bondhas anembedded optionthat gives a bondholder the right to convert their bond into the equity of the issuing company or a subsidiary. An interest-paying convertible bond will makecoupon paymentsto bondholders for the duration of time the bond is held.
After the bond has been converted to shares of the issuer, the bondholder stops receiving interest payments. At the time an investor converts a convertible bond, there will usually be one last partial payment made to the bondholder to cover the amount that has accrued since the last payment date of record.
For example, assume interest on a bond is scheduled to be paid on March 1 and September 1 every year. If an investor converts his bond holdings to equity on July 1, he will be paid the interest that has accumulated from March 1 to July 1. This final interest payment is the accrued interest adjustment.
Example of Accrued Interest on a Bond
Suppose investor A purchases a bond in the primary market with a face value of $1,000 and a coupon of 5% paid semi-annually. After 90 days, investor A decides to sell the bond to investor B. The amount investor B has to pay is the current price of the bond plus accrued interest, which is simply the regular payment adjusted for the time investor A held the bond.
In this case, the bond would be $50 over the entire year ($1,000 x 5%), and investor A held the bond for 90 days which is a quarter of the recorded year, or 25% (calculated by 90/360). So, the accrued interest ends up being $12.50 ($50 x 25%). So investor B will have to pay investor A the value of the bond in the market, plus $12.50 of accrued interest.
Do You Pay Taxes on Accrued Interest?
Generally speaking, interest that accrues on bonds is subject to taxes. If you earned $10 or more in interest, you will be issued a 1099-INT, a tax form that reports interest income.
Is Accrued Interest a Good Thing?
Accrued interest can be financially beneficial for the owner of a bond. Simply put, accrued interest is money that grows over time based on interest rate and the amount originally borrowed. Whether or not accrued interest is an ideal way to save or grow wealth depends on other saving and earning options available.
What Is the Difference Between Interest and Accrued Interest?
Regular interest is paid out more immediately than accrued interest. Consider a savings account at a bank. In most cases, interest is calculated and paid out on a monthly basis. By comparison, accrued interest grows regularly, but payments are made on a longer term basis, typically every six months.
The Bottom Line
Accrued interest is a type of interest that is earned on a debt—such as a loan or a bond—but that has not yet been collected. While interest accumulates over time, it may only be paid out every six months or more. When you buy a bond, you may need to pay out accrued interest to the former bond owner to reflect the interest that accumulated during the window prior to the purchase.
