Melanie wrote: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
![Smile :)](./images/smilies/icon_e_smile.gif)
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