Buying bonds part-way through the coupon payment period

[TheMotorcycleBoy]

Hi all,

If I were to purchase bonds in say, June, and the coupon payment date was December, with a payment made once a year, would I receive only 6 months coupon payment? What about the person selling them - would they receive any of the coupon payment if they sold 6 months before the yearly payout or is this all taken care of in the buy/sell price?

Hope that makes some kind of sense!

Mel

[moorfield]

If I were to purchase bonds in say, June, and the coupon payment date was December, with a payment made once a year, would I receive only 6 months coupon payment? What about the person selling them - would they receive any of the coupon payment if they sold 6 months before the yearly payout or is this all taken care of in the buy/sell price?

Yes you would each receive part of the coupon payment, in your example (roughly) a 50/50 split. If you purchased the bond in say, November, then the seller would receive most of the coupon payment (roughly) a 90/10 split. The amount accrued between coupon dates is indeed reflected in the price which is called the "dirty" price in bond dealing. Not to be confused with the "clean" price which strips out that amount and is used as the conventional price between bond dealers.

[hiriskpaul]

Just to be clear, the price quoted for a bond does not normally include the accrued interest adjustment, but this can sometimes be the case. Always check with the dealer whether it is a "clean price", in which you would pay (or receive if in ex-div period) accrued interest on top of the price you have been quoted. Dirty prices are usually only quoted in special circumstances, such as when the bond is in default, but best to always check with the dealer.

[AleisterCrowley]

This was something I didn't known when I started getting interested in bonds a year or two back. It's rarely covered in articles for bond beginners ..
I still don't really understand why this happens: wouldn't it be easier to allow the accrued coupon to be reflected in the price?

[Alaric]

I still don't really understand why this happens: wouldn't it be easier to allow the accrued coupon to be reflected in the price?

There's a difference in taxation treatment which in the days when capital gains were taxed differently from interest could make a difference.

By my understanding if you hold a Bond at the ex-dividend date, you get the whole payment regardless of how long you've held it. You will however have compensated the previous owner for their loss of a proportion of that income by paying more for the Bond through the accrued income mechanism. Particularly where there are nominee holdings the issuer of the Bond doesn't know or care how long individuals have held them.

[GoSeigen]

Hi all,

If I were to purchase bonds in say, June, and the coupon payment date was December, with a payment made once a year, would I receive only 6 months coupon payment? What about the person selling them - would they receive any of the coupon payment if they sold 6 months before the yearly payout or is this all taken care of in the buy/sell price?

Hope that makes some kind of sense!

Mel

Melanie, the answer to this is tricky, and most investors have not got it clear in their minds. Please forgive me if the following explanation is too didactic, however my words are chosen carefully and the meaning is hopefully precise.

1. When you purchase a bond in the secondary market, someone else sells the same bond. The purchaser gives cash in consideration, the seller receives that cash. No interest, coupon, or anything else changes hands. Only the bond and the cash consideration.

2. The value of the bond is the total value of the bond as calculated by each of the buyer and the seller. They arrive at this value by considering all the cashflows they will receive from the issuer and the timings thereof. Then the cash consideration equals this value. No interest or coupon or partial coupon changes hands.

3. Now, you will observe that an issuer (especially governments) hypothetically could issue bonds that differ materially only in their coupon payment dates. You could consider the value of two such bonds to be made up of two parts: a portion accounted for by the respective accrued coupons -- we call this "accrued interest", and the remainder of their value which we call the "clean price". The first portion i.e. accrued interest differs for each of the bonds; the second portion i.e. clean price is theoretically the same for the two bonds.

4. Further, you have correctly observed that bond coupons are an unavoidable liability of the issuer, and that a holder of the bond "earns" the coupon over time through giving up the use of the capital he paid in consideration. Therefore at any moment between consecutive coupon payments any holder has "earned" part of the coupon and will earn the remainder if he remains a holder. The amount he has earned is unsurprisingly the same value as the "accrued interest" defined and named in (3) above.

5. In 3. and 4. we saw two ways that the abstract concept "accrued interest" is useful. There is a third, less abstract use: taxation. In UK tax law there is a protocol called the "Accrued Income Scheme" which lays out how liability for income tax on coupons is apportioned between a buyer and a seller. Putting it simply, the AIS says that a bond buyer is not liable to income tax on interest already "accrued" since the last coupon payment. Similarly the seller is not liable to any tax on the interest that will be accrued after the bond's sale. The above "accrued interest" value again represents the amount of a bond's value that is subject to income tax at sale.

6. For the above three reasons, and perhaps others, it has become common practice for exchanges to quote all bond prices using the "clean" price. You will see this clean price quoted by you brokers, in lists of reported sales, charts of bond prices etc etc. Clearly a potential trader on an exchange is required to add the "accrued portion" to the clean price quoted to determine the full bid or offered price (known as "dirty price"). When a trade occurs on the exchange, the consideration which changes hands is the dirty price, equal of course to the value we discussed in 2. above.

7. From the foregoing you hopefully understand now that actual interest does no change hands in a bond trade. Accrued interest is a purely notional value broken out of the price for the convenience of market participants. It is quoted by brokers on trade confirmations so that you can enter the value in your income tax return for the Accrued Income Scheme entries.

8. Notional it may be, but it is still important to be aware of the above for the following reasons:
-it helps with your tax returns.
-you need to be aware prices are quoted "clean" and to add back accrued interest to determine the full price being demanded or offered for a bond.
-you need to be aware that sometimes prices are quoted dirty: importantly, when the bond is in default so no coupon is expected, but also for fixed interest securities which are NOT bonds. e.g. Preference shares being share capital pay dividends and not interest and are always quoted dirty -- they are not subject to the AIS.



So to summarise, here's the "quick" answer to your question which I repeat:

If I were to purchase bonds in say, June, and the coupon payment date was December, with a payment made once a year, would I receive only 6 months coupon payment? What about the person selling them - would they receive any of the coupon payment if they sold 6 months before the yearly payout or is this all taken care of in the buy/sell price?

No, the parties would not receive or pay any coupon amount at all. Neither would any interest payment be made by your broker, the market maker or the issuer. The cash consideration is the full value of the bonds and the only actual cash amount exchanged between the parties excepting commissions of course.

There is however a purely notional value known as "accrued interest" calculated in this case as equal to six months' worth of coupon. This value is subtracted from the full price to give a notional "clean price" -- which was probably quoted by your broker if that was how you transacted. The "accrued interest" is also the amount you need to subtract from the first coupon you receive for the Interest Received section of your self assessment return.

[Note this all is totally different to Stamp Duty on shares where an actual amount is remitted buy the purchaser to HMRC.]


Hopefully that is understandable! Please ask if confused about anything.

GS

[TheMotorcycleBoy]

Hi GS,

( I did try to reply to your PM, but LF wouldn't allow me to for some reason!)


Regarding the purchase of bonds part-way through the coupon payment period, I think I understand what you're saying, but would be more confident of my thinkings if you could confirm my calculations with my good old favourite example of Anglian Water (40LV) XS0089553282.

6. For the above three reasons, and perhaps others, it has become common practice for exchanges to quote all bond prices using the "clean" price. You will see this clean price quoted by you brokers, in lists of reported sales, charts of bond prices etc etc. Clearly a potential trader on an exchange is required to add the "accrued portion" to the clean price quoted to determine the full bid or offered price (known as "dirty price"). When a trade occurs on the exchange, the consideration which changes hands is the dirty price, equal of course to the value we discussed in 2. above.

So with a current listed buy price on HL site of £127.65 (100 units), a coupon of 6.875% and an annual coupon being paid in August (approx. 5 months until coupon payout), not taking into account any commissions, if I were to buy 100 units, would I be paying the following:

£127.65 (clean price?) +
7 months of accrued interest (6.875/12 *7) = £4.01

A total payment of £131.66 (dirty price?)

Is this correct?

Many thanks for your time and patience!

Mel

[GoSeigen]

Hi GS,

( I did try to reply to your PM, but LF wouldn't allow me to for some reason!)

That was my settings. I've fixed them now.

So with a current listed buy price on HL site of £127.65 (100 units), a coupon of 6.875% and an annual coupon being paid in August (approx. 5 months until coupon payout), not taking into account any commissions, if I were to buy 100 units, would I be paying the following:

£127.65 (clean price?) +
7 months of accrued interest (6.875/12 *7) = £4.01

A total payment of £131.66 (dirty price?)

Is this correct?

Yes, the calculation looks right and all the correct terminology as well. Well done!



Regarding the coupon change: here is what the 2003 AWS Annual Report says:

https://www.anglianwater.co.uk/_assets/ ... t-2003.pdf
Debt refinancing
On 30 July 2002 the financial restructuring of the company was concluded. This involved the transfer of debt previously raised by AWG Group Limited (AWGL) to AWSF and the raising of new debt in the financial markets which increased the overall level of gearing.
The additional financing was carried out through AWSF. All borrowings raised by AWSF were on-lent to the company.
At the same time, all new and existing debt was transferred on to a common set of terms and conditions governed by the Common Terms Agreement (CTA) which also sets out the convenant requirements imposed by lenders.



And the RNS announcing the CTA says:

https://www.investegate.co.uk/article.a ... 700444879T
(2) £150m 3 7/8 per cent IL 2020, £200m 6 5/8 per cent 2023 and £200m 6 3/8 per cent. 2029 (these bonds are guaranteed by AWS but do not have financial ratio covenants).

It is proposed that their coupons are increased by 0.25 per cent p.a., with provision for:

* a further increase of 0.25 per cent p.a. in the event that any one of the rating agencies lower their ratings for the class A debt from A-/A3/A- level to BBB+/Baa1/BBB+ and

* a further increase of 0.25% p.a. in the event that one of the rating agencies lower their ratings for the class A debt to BBB/Baa/BBB.

On subsequent return to the previous rating by all the agencies, the relevant step-up would fall away.


GS

[TheMotorcycleBoy]

Hi GS,

( I did try to reply to your PM, but LF wouldn't allow me to for some reason!)

That was my settings. I've fixed them now.

Much appreciated, sorry in advance if I/we pester you too much PMing you!

So with a current listed buy price on HL site of £127.65 (100 units), a coupon of 6.875% and an annual coupon being paid in August (approx. 5 months until coupon payout), not taking into account any commissions, if I were to buy 100 units, would I be paying the following:

£127.65 (clean price?) +
7 months of accrued interest (6.875/12 *7) = £4.01

A total payment of £131.66 (dirty price?)

Is this correct?

Yes, the calculation looks right and all the correct terminology as well. Well done!

Bloody-blimey, understood it right first time.....Go me

Regarding the coupon change: here is what the 2003 AWS Annual Report says:

https://www.anglianwater.co.uk/_assets/ ... t-2003.pdf
Debt refinancing
On 30 July 2002 the financial restructuring of the company was concluded. This involved the transfer of debt previously raised by AWG Group Limited (AWGL) to AWSF and the raising of new debt in the financial markets which increased the overall level of gearing.
The additional financing was carried out through AWSF. All borrowings raised by AWSF were on-lent to the company.
At the same time, all new and existing debt was transferred on to a common set of terms and conditions governed by the Common Terms Agreement (CTA) which also sets out the convenant requirements imposed by lenders.



And the RNS announcing the CTA says:

https://www.investegate.co.uk/article.a ... 700444879T
(2) £150m 3 7/8 per cent IL 2020, £200m 6 5/8 per cent 2023 and £200m 6 3/8 per cent. 2029 (these bonds are guaranteed by AWS but do not have financial ratio covenants).

It is proposed that their coupons are increased by 0.25 per cent p.a., with provision for:

* a further increase of 0.25 per cent p.a. in the event that any one of the rating agencies lower their ratings for the class A debt from A-/A3/A- level to BBB+/Baa1/BBB+ and

* a further increase of 0.25% p.a. in the event that one of the rating agencies lower their ratings for the class A debt to BBB/Baa/BBB.

On subsequent return to the previous rating by all the agencies, the relevant step-up would fall away.

Thanks for this, I'll get Hubby to read this bit as he was puzzled by it I believe, but it kind of makes sense now you've very helpfully provided the info to clear up the confusion.

Mel

[hiriskpaul]

£127.65 (clean price?) +
7 months of accrued interest (6.875/12 *7) = £4.01

A total payment of £131.66 (dirty price?)

I would agree with that as well, but as you say only approximately. Accrued interest is calculated daily and although precise accrual calculations can and do vary, the way it works for this particular bond follows the prospectus as "If interest is required to be calculated for a period of less than one year, it will be calculated on the basis of a 360-day year of 12 months of 30 days each". This is called the 30/360 convention, although precisely which variant of 30/360 is not clear from the prospectus. You would need to ask your broker what precise convention has been adopted. If you bought today though, for settlement Friday all the various calculations work out the same, it is just at month end when the calculations vary. To work out the number of days on a 30/360 convention between 21/08/17 (previous coupon payment date) and Friday 6/04/18, you do it like this:

difference in years * 360 = 360
difference in months * 60 = -4 *30 = -120
difference in days = 6 - 21 = -15

Add them all up to get the number of days 360 -120 -15 = 225 days accrued.

The interest per £100 nominal is then 6.875*225/360 = £4.296875

You probably don't care about any of that (most investors don't), but I think it worthwhile remembering that accrued interest is calculated up until settlement date rather than trade date.

p.s. I have noticed that the prospectus stipulates various call and put options and as GS has pointed out, the terms of the bonds have been amended at least once since issue. Make sure you understand and are comfortable with the conditions before you invest!

[hiriskpaul]

This was something I didn't known when I started getting interested in bonds a year or two back. It's rarely covered in articles for bond beginners ..
I still don't really understand why this happens: wouldn't it be easier to allow the accrued coupon to be reflected in the price?

There was a time when some bond market quotes were dirty rather than clean. I vaguely remember French OAT prices were quoted that way. That was a bit of pain as computer systems had to be coded to handle the various idiosyncrasies and you had to be very careful performing bond calculations, such as fitting implied yield curves. I think all markets have adopted clean quoting now, probably more because there was no way the largest market (US Treasuries) would change what they were doing rather than any particular advantage of clean over dirty pricing.

Most if not all accounting/tax regimes do require interest to be accounted for separately from capital, so it is useful for bonds to trade with explicitly separated out accrued interest, but that is not really the reason why clean prices are quoted instead of dirty prices.

[TheMotorcycleBoy]

£127.65 (clean price?) +
7 months of accrued interest (6.875/12 *7) = £4.01

A total payment of £131.66 (dirty price?)

I would agree with that as well, but as you say only approximately. Accrued interest is calculated daily and although precise accrual calculations can and do vary, the way it works for this particular bond follows the prospectus as "If interest is required to be calculated for a period of less than one year, it will be calculated on the basis of a 360-day year of 12 months of 30 days each". This is called the 30/360 convention, although precisely which variant of 30/360 is not clear from the prospectus. You would need to ask your broker what precise convention has been adopted. If you bought today though, for settlement Friday all the various calculations work out the same, it is just at month end when the calculations vary. To work out the number of days on a 30/360 convention between 21/08/17 (previous coupon payment date) and Friday 6/04/18, you do it like this:

difference in years * 360 = 360
difference in months * 60 = -4 *30 = -120
difference in days = 6 - 21 = -15

Add them all up to get the number of days 360 -120 -15 = 225 days accrued.

The interest per £100 nominal is then 6.875*225/360 = £4.296875

You probably don't care about any of that (most investors don't), but I think it worthwhile remembering that accrued interest is calculated up until settlement date rather than trade date.

p.s. I have noticed that the prospectus stipulates various call and put options and as GS has pointed out, the terms of the bonds have been amended at least once since issue. Make sure you understand and are comfortable with the conditions before you invest!

Thanks for this info, definitely worth keeping in mind. We're not necessarily thinking of buying this particular bond, it's just the one we keep referring to to use as an example for us to try and learn from, but yes, we definitely need to go through the conditions with a fine toothed comb before proceeding with any purchases.

Thanks again,

Mel