Accrued interest

Definition: The amount of interest that is built up between periodic (ie: regularly scheduled) bond interest payments. The seller of a bond wants to be paid this interest when he or she sells a bond any time between interest payments.

Example: A bond has an interest rate of 6%, meaning that it earns the holder 6% of its $1,000 face value, or $60 in interest per year.  Companies typically pay interest twice per year, so the holder of a 6% bond will actually receive interest payments of $30 every six months. Notice that the interest in our example is $5 per month.

Let’s say that a month before the next interest payment is going to be made, the owner of the bond can’t wait for the payment and must sell the bond now. She realizes that whoever she sells the bond to will receive the next $30 interest payment in just a month. This seems unfair because she’s held the bond for five of the six months between interest payments. To be treated fairly, she ensures that in addition to a fair price for the bond, the buyer pays her the $25 (ie: $5 per month x 5 months) interest that has accrued. The buyer agrees to this because in just a month, he, as the new owner, will receive the $30 interest payment. This makes up for the $25 paid he paid to the seller, with the $5 difference representing interest for the one month he’s owned the bond.

Investeach explains: A bond that does not trade with accrued interest is known to trade “flat”. The primary reason for a bond to trade flat is that the company has been unable to pay the interest it has promised to pay, so investors don’t have much confidence that any future interest will be paid to them by the company.

Riddle me this:

1. What occurs between periodic bond interest payments?
2. Over what period of time will it take for a company to pay the interest stated on the bond?
3. How frequently do companies actually pay interest on their bonds?
4. When a person buys a bond from another person in between bond payments, besides paying for the bond itself, what else will the person pay?
5. How do we compute the amount of accrued interest the buyer should pay?