Does a bond experience the inverse of the price deterioration seen on an option, the closer it is to a coupon date? For example, suppose you purchase a \$1,000 bond with a 10% coupon, which pays \$50 a year in two installments on June 15 and Dec. 15. If the bond is trading at par (100 cents on the dollar), does it experience a natural growth toward 105 as it approaches a payment date? -- Gordon Shephard

Gordon,

Your logic is impeccable, but no, that's not how it actually works.

You correctly assume that if a bond changes hands a certain number of days after its last coupon payment, the seller should get whatever portion of the

next

coupon payment he is entitled to, based on how long he held the bond.

Fixed-Income Forum: Join the discussion on

TSC

message boards. Sellers do in fact get that payment. In bond-market lingo, it's called "accrued interest." But industry convention is to account for accrued interest separately from the price of the bond.

For example, suppose you buy a Treasury bond today at 99, or \$990 per \$1,000 of face value, to settle on Wednesday. This Treasury bond has a 6% coupon and makes \$30 interest payments every Feb. 15 and Aug. 15.

You are buying the bond on the 122nd day of a payment period that has 184 days. The seller is therefore entitled to 121/184 of the Feb. 15, 2000, coupon payment. A quick calculation shows that amount to be \$19.80.

121/184 = 0.66

0.66 * \$30 = \$19.80

So, the full price of your bond, as opposed to the

quoted

price, would be \$1009.80 -- \$990 plus \$19.80.

It makes sense to account for accrued interest separately -- rather than having it be reflected in the quoted price -- because that way bonds with different payment dates can be compared apples to apples, rather than having to figure out what portion of each bond's price represents accrued interest.

A couple of other points. According to Robert Zipf's book

How the Bond Market Works

, accrued interest is calculated slightly differently for corporate and municipal bonds than for Treasuries. In those calculations, all months have 30 days, and a year is 360 days. So, if the bond in the example were a corporate, you would calculate the accrued interest as follows. (The seller would be entitled to 120/180 of the next coupon payment.)

120/180 * \$30 = \$20

Also note that preferred stock, a stock-bond hybrid that was discussed in a previous

Fixed-Income Forum, doesn't work this way. It works the way you thought bonds worked -- the seller's accrued interest is reflected in the quoted price of the security.

For example, preferred shares have \$25 par amounts. So, a preferred share with an 8% coupon would pay \$2 a year, in quarterly installments of 50 cents. A share trading at par would gradually increase to 25 1/2 as it approached its dividend date. And immediately upon paying its dividend, it would drop back to 25 and start the process over again.

Also note that bonds

do

experience price deterioration comparable to what happens with options as they approach

maturity

, as opposed to the coupon date. As it ages, a bond will tend to trade at a premium, simply as a function of time. If you buy a 10-year bond with a 6% coupon at par and hold it for five years, it will be a five-year bond with a 6% coupon.

Assuming interest rates haven't changed much, new five-year bonds selling at par won't carry 6% coupons. So, the larger coupon on your five-year bond would make someone else willing to pay more than par for it. But because the bond will mature at par, as its maturity date approaches, its market price will return to par.

TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.

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