6.5.6. Calculating Accrued Interest
Municipal bonds typically pay interest semiannually, but interest is earned daily. When an investor purchases a bond in the secondary market, interest has already been accumulating since the last coupon payment. This accrued interest is added to the purchase price of the bond. Why? Let’s have a look.
Example: Adrian buys a block of Detroit 5% general obligation bonds (face value $50,000) on Friday, June 21. On July 1 he is due to receive a semiannual interest payment of $1,250, which has been accumulating since January 1. Most of this accrued interest has been earned by the previous owner, who will feel cheated if the new owner receives interest for the entire period. To compensate the seller, Adrian must add to the purchase price of the bonds all the interest that has accrued up to the settlement date. The settlement date is two business days after the trade date.
Accrued interest for municipal bonds is calculated in the same way as corporate bonds, which assume a 360-day year and 30-day month (the 30/360 convention). Accrued interest is calculated starting with the last coupon date up to, but not including, the settlement date of the sale. The settlement date for municipal securities occurs two business days after the trade date.
Sample Question
On settlement date, how much will Adrian have to pay in accrued interest for the general obligation bonds he bought in the previous example?
Answer: $1,208.33. The settlement date is two business days after Friday the 21st of June. That would be Tuesday the 25th. Using