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Accrued Interest Adjustment
Accrued interest adjustment is the taxable income reduced by reducing the extra amount of interest given to the convertible bondholder or to other fixed-income securities. Similar to the ordinary interest, accrued interest adjustment is also entitled to taxation.
For this reason, the accrued interest adjustment is used to reduce the taxable interest income. This is done by reducing the extra amount of interest that is payable to the fixed-income security owner.
A Little More on What is Accrued Interest Adjustment
Generally, the accrued interest adjustment vary depending on the elapsed number of days. This is normally from the last interest payment date and the last conversion date. However, this does not include the date of the settlement.
How Accrual Interest Adjustment Works
Basically, there is an embedded option in the convertible bond. It is this embedded option that gives the security holder the right to convert his or her security into equity. This is from either the issuing company or from the subsidiary.
The security holder will get coupon payment from the convertible bond that earns interest. This coupon paid to the shareholder is usually for the period in which the bond was held.
During bond conversion, there is one final payment given to the security holder. This is for the purpose of covering the amount that accrued from the last payment date.
For instance, suppose there is an interest in a security that is to be paid on April 1 and October 1 on a yearly basis. If an investor decides to convert his security holding to equity on August 1, he is given the interest. The interest being given is basically the one which accrued from April 1 to August 1. This payment is what is referred to as accrued interest adjustment.
In addition, when purchasing bonds in the secondary market, the person purchasing pays for the accrued interest. In this case, the accrued interest is paid to the bond seller. This is part of the amount earned from the price’s purchase total amount. An investor who purchases a bond also becomes the record’s bondholder between the last and future coupon payment. For this reason, he is entitled to full interest on the scheduled date of coupon payments.
Nevertheless, the purchaser must pay the seller of the bond part of the earned interest. This is because the bond’s purchaser will not have earned the entire interest that accrued during this period. The part of interest in question is the one that was earned before the bond was sold.
Areas where accrual interest adjustment can be used
Accrual interest adjustment can be used when working on the following:
- Bondholder’s entries
- Issuer’s accrued interest
- Issuer’s payable interest
Uses of Accrued Interest Adjustment
There are various ways in which accrued interest adjustment can be used. The uses are as follows:
- To reduce the taxable interest earnings. This is done by reducing the extra amount of interest that is payable to the fixed income security owner.
- To ensure that the entries adjusted for the accrued interests are reported within their period of earning and not at a later date.
The Bottom Line
Basically, most of the entry adjustments made by the issuers and investors are usually associated with the bond’s accrued interest. Note that the accrued interest applies to both earned and owed interest.
Therefore, firms that invest in bonds will require entries for both accrual interest and future payments. So, whichever side, making an adjustment on the bond’s accrued interest is important as it prevents double entities on a balance sheet.
Reference for “Accrued Interest Adjustment”
Academics research on “Accrued Interest Adjustment”
[PDF] North Korea-Japan Relations: The Normalization Talks and the Compensation/Reparations Issue, Manyin, M. E., & Foreign Affairs, Defense, and Trade Division. (2001, June). North Korea-Japan Relations: The Normalization Talks and the Compensation/Reparations Issue. Congressional Research Service, Library of Congress.
Par-Par Asset Swap Spreads: An Illustration of How to Price Asset Swaps, Burgess, N. (2016). Par-Par Asset Swap Spreads: An Illustration of How to Price Asset Swaps. Available at SSRN 2809111. Asset swaps provide a form of asset financing, where investors borrow funds to purchase an asset, typically a bond. Asset swaps are also a good bond rich-cheap analysis tool. Such swaps can of course be used for speculative purposes. In this paper we provide a brief overview of asset swaps and derive a par-par asset swap spread formula incorporating bond accrued interest. Finally we illustrate how to calculate both the yield-yield and par-par asset swap spread using the liquid 10 year German Bund.
Strengthening Treasury Direct, Coffey, W. J. (2001). Strengthening Treasury Direct. Wise investors in Treasury securities can deal directly with the Bureau of the Public Debt by opening a Treasury Direct account with a Federal Reserve Bank, thus avoiding charges imposed by banks and brokerage firms that frequently act as intermediaries for Treasury securities investors. Although there are several advantages to investing in Treasury securities, certain practices followed by the Federal Reserve Bank reduce interest rightfully due investors.
This article cites examples of how the Federal Reserve Bank takes unfair advantage of its investors by avoiding full payment of interest. Investor record keeping problems also arise when the Federal Reserve Bank reopens a previously issued security. Recommendations are made for strengthening the Treasury Direct system with specific suggestions on how to achieve fair treatment for investors.
The muni bond spread: Credit, liquidity, and tax, Ang, A., Bhansali, V., & Xing, Y. (2014). The muni bond spread: Credit, liquidity, and tax. Columbia Business School Research Paper, (14-37). Municipal (muni) bonds are risky and trade in illiquid markets, and both effects serve to raise muni yields relative to Treasuries. On the other hand, the tax exemption of muni bonds tends to lower their yields. We decompose the muni yield spread into credit, liquidity, and tax components. Before 2008, muni yields are reliably lower than Treasuries. After the 2008 financial crisis, the muni-Treasury spread flips sign to, on average, 0.87%, comprising credit, liquidity, and tax components of 0.57%, 2.14%, and -1.84%, respectively. Muni credit and liquidity components exhibit strong covariation with credit and liquidity factors prevailing in other asset classes.
On the Calculation of “Real” Investment Returns, Wilkie, A. D. (1984). On the Calculation of “Real” Investment Returns. Transactions of the Faculty of Actuaries, 39, 105-130.