Accrued interest is the portion of interest paid to the investor on the next interest payment date that the investor has not earned.
How Municipalities Calculate Accrued Interest
When calculating accrued interest, municipal securities use the standard 30/360 date basis. Treasuries use the actual number of days in the month and year.
When you calculate the number of days of accrued interest, you do not include the purchase date, but you do include the next interest payment date.
An investor holds a $100 municipal security paying 5% interest annually, with the next interest payment being on 12/1/2022. If the investor sells the security at par on 6/1/2022, there would be $2.50 of accrued interest, putting the security’s cost at $102.50. The accrued interest occurs because the new investor will be receiving $5 in interest on 12/1/2022, but they only earned interest starting 6/1/2022.
What’s important here?
Accrued interest can occur in two situations:
- An investor purchases a security in the primary market, called the initial issuance, and the dated date and the delivery date do not match, or
- An investor purchases a security in the secondary market, such as from an existing investor, during an interest period.
In both situations, the investor will receive a full interest payment on the next interest payment date even though they did not own the security during the full interest payment period. They must add the value of the accrued interest to the purchase price of the security when they buy it.
If a municipality sells a $100 bond for $102.50, due to the interest it’s earned, but not yet paid out, it needs to make sure it accounts for the accrued interest separately, so as not to overstate its bond liability. In this case, the municipality would record receiving $102.50 cash, but only record the $100 face value of the bond as a liability. The other $2.50 would be recorded against earned interest.
The purchaser would record paying out $102.50 cash, but only record $100 as a future receivable for the bond face value. The other $2.50 would be recorded as a liability for accrued interest — this would be offset when the first interest payment is received.