Accrued Interest

What is Accrued Interest ?

Accrued interest is the amount of interest that has accumulated on a debt security since the last interest payment date, but has not yet been received or paid out. It represents the interest that has been earned by the bond or other security holder but has not yet been realized.

How does accrued interest work ?

To understand how accrued interest works, it is important to first understand how bonds and other fixed-income securities work.

Bonds are a type of debt security issued by companies, governments, and other organizations to raise money. When an investor buys a bond, they are essentially lending money to the issuer of the bond. In return, the issuer promises to pay the investor a fixed rate of interest on a regular basis, typically every six months. At the end of the bond's term, the issuer repays the principal amount of the bond to the investor.

Accrued interest comes into play because the interest payments on a bond are made on a fixed schedule, typically every six months. However, if an investor buys or sells a bond outside of the period between interest payments, the buyer or seller must compensate the other party for the interest that has accrued since the last interest payment.

For example, suppose an investor buys a bond with a face value of $1,000 that pays a fixed interest rate of 5% per year. The bond pays interest every six months, so the investor can expect to receive $25 every six months ($1,000 * 5% / 2). However, if the investor buys the bond in the middle of the six-month period between interest payments, they will owe the seller the interest that has accrued since the last interest payment. If the last interest payment was made three months ago, then the investor would owe the seller $12.50 ($25 / 2 * 3 / 6).

Accrued interest can also come into play when a bond is sold before it reaches maturity. In this case, the buyer must compensate the seller for the interest that has accrued since the last interest payment, up to the date of the sale.

Why is accrued interest important ?

Accrued interest is important for several reasons, including:

1. Fair pricing: Accrued interest is an essential component of the pricing of fixed-income securities. When an investor buys or sells a bond, the accrued interest must be factored into the transaction price to ensure that the buyer and seller are paying a fair price for the security.
2. Accurate accounting: Accrued interest is also important for accurate accounting of fixed-income securities. Investors must account for the accrued interest on their fixed-income investments when calculating their investment returns and tax liabilities.
3. Investment decision-making: Accrued interest can also play a role in investment decision-making. Investors who are considering buying or selling a bond must take into account the accrued interest to ensure that they are making informed decisions about the value of the security.
4. Risk management: Accrued interest is also important for managing risk in fixed-income portfolios. Investors who are holding a bond that has accrued a significant amount of interest may be exposed to greater risk if interest rates rise, as the value of the bond may decline.
5. Regulatory compliance: Finally, accrued interest is an important consideration for regulatory compliance. Financial institutions and other market participants must follow various rules and regulations related to the reporting and accounting of accrued interest on fixed-income securities.

3 Benefits of accrued interest 

1. Accurate valuation: Accrued interest is an important factor in determining the current value of a financial instrument. When a bond is traded, the buyer pays the seller the market price of the bond plus the accrued interest. Accrued interest helps to ensure that the buyer pays a fair price for the bond.
2. Cash flow management: For investors who hold bonds or other fixed income securities, accrued interest can provide a regular stream of income. This can help to improve cash flow management and provide a steady source of income.
3. Tax benefits: Accrued interest can provide tax benefits for investors. For example, if an investor holds a bond that pays interest annually, they may be able to defer paying taxes on the accrued interest until the bond is sold or matures.

4 Examples of accrued interest 

Here are a few examples of accrued interest:

1. Corporate bonds: When a bond is sold between interest payment dates, the buyer must pay the seller the market price of the bond plus the accrued interest since the last payment date.
2. Treasury bills: Treasury bills are short-term debt securities issued by the US government that are sold at a discount to their face value. When sold before maturity, buyers must pay the market price plus accrued interest.
3. Mortgage loans: When a borrower makes a payment on a mortgage loan, the payment is first applied to the accrued interest before being applied to the principal. This helps to ensure that the lender receives the interest that they are owed.
4. Certificates of deposit (CDs): CDs are a type of savings account that pays a fixed interest rate for a specified period of time. If a CD is cashed out before its maturity date, the investor may be required to forfeit some of the accrued interest.