When the broker "shows" you a bond (that is the term generally used), she will say something like "I want to show you this great bond we just got in. It is the State of Bliss 7¼ of 05, and it is priced at 96 bid and 97 ask." Well, what did she say?
Actually, that statement is easily decoded. Bonds are always identified by several pieces of information; namely, the issuer (State of Bliss); the coupon (7¼); the maturity date, of "05"; and the price, quoted as 97.
Let us examine each of those details more closely. First, the coupon. Coupons are always quoted in percentages. That percentage is set at issue and is therefore a percentage of par. The percentage value, however, is immediately translated into a fixed dollar amount, and that amount remains the same throughout the life of the bond, no matter what happens to the price of the bond. In the previous example, the 7¼ coupon represents 7¼% of $1,000, that is, $72.50. Unless stipulated otherwise, coupons are paid semiannually. You will receive half of that amount, that is, $36.25, twice a year, for as long as the bond remains outstanding. (Floating-rate bonds vary from this pattern. For floating-rate bonds, coupon rates are reset at predetermined intervals.)
The maturity date is designated by the last two digits, in this instance, 05. This has to be 2005. Note that with few exceptions, bonds are not issued with maturities above 30 years.
Finally, the price was quoted as 97. Bond prices are quoted in percentages, and again, percentages of par. So the quote of 97 should be interpreted as 97% (or 0.97) times $1,000, which equals $970. To compute price, add a zero to the percentage quote.
You can now translate what the bond broker is telling you. She would like to sell you a State of Bliss bond, maturing in 2005, with a coupon of $72.50, at a price of $970.
Accrued Interest: Let us suppose you decide to buy the State of Bliss bonds. When you receive your confirmation notice, it is probable that the price will turn out to be somewhat higher than the $970 that you were quoted. No, the broker is not ripping you off. The difference between the price that you pay and the $970 that you were quoted is "accrued interest." Let's explain.
You will remember that interest payments are made twice a year. But actually, bonds earn (the Wall Street word is "accrue") interest every single day. The owner of a bond earns or accrues interest for the exact number of days that he owns the bond.
Now suppose you are buying the State of Bliss bonds three months after the last coupon payment was made (and, therefore, three months before the next interest payment occurs). In three months, you will receive an interest payment for the past six months; but you will have earned that interest for only three months. The gentlemanly thing to do is to turn over three months' worth of interest to the previous owner.
In fact, that is what you do when you buy the bond—only you do not have any choice in the matter. The three months' interest due to the previous owner is automatically added on to the purchase price. The buyer pays the seller the accrued interest. When you (the buyer) receive the next coupon payment, the interest you receive will cover the three months' worth of interest you earned and the three months of interest that you paid the previous owner.
Accrued interest is easily computed. For bond pricing purposes, for many bonds (but not for notes), the year has 360 days. To compute accrued interest, divide the annual coupon by 360 days and multiply the result by the number of days accrued interest is owed. Add accrued interest to the purchase price. The day count varies somewhat, depending on the type of bond.
Accrued interest is paid on par, premium, and discount bonds. The amount of accrued interest depends entirely on the coupon, divided by the number of days interest is owed. It has nothing to do with the price.
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