Accrued Interest Assignment Help

Accrued interest is the amount of interest that has been earned by the seller of a bond but is paid to the buyer (as the holder of record date for the next coupon payment). It is the interest earned between the previous coupon payment date and the date of the transaction. There are a number of different conventions depending on market practice as to how the accrued interest is calculated. What is important is that at the transaction date both parties know exactly what portion of the coupon belongs to each party.

Full price is when the price of the bond traded includes the accrued interest. It is a convention in the United States that bonds trade at full price, or dirty price. Clean price is when the price excludes the accrued interest.

Early retirement provisions

The issuer may be given the flexibility (a right not an obligation) to retire bonds prior to the stated maturity date. Remember that this is an option that modifies the cash flows of a bond and hence may affect the expected return.

This early retirement would be achieved with:

A call provision is the right of an issuer to redeem all or part of an outstanding issue prior to the stated maturity date. An example of a call provision is that an issuer may redeem, say, a 10%-coupon bond when the market interest rate declines to a certain level, say, 5%.

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The price that the issuer must pay to retire the bond using this call option is called the call price. The call price is in most cases higher than par and there is typically a call schedule, i.e. different call prices on different call dates. The higher call price is intended to compensate the investors for the loss of maturity.

Issuers are restricted on the earliest date they can exercise the call option. It is typically a number of years after the issue date, because the investor must be given the assurance that the bond is initially intended as a medium or long-term instrument, otherwise investors might as well invest in short-term money market instruments. This feature of an issue is called a deferred call. The first call date is the date when the bond may first be called. The implication of call provisions is that there will be different computed yields for different call dates.

An issuer can call the bond in its entirety or simply in part. When it is called in part, there are two ways that an issuer can select which certificates are to be redeemed, i.e. on a random or on a pro rata basis. The pro-rata basis is rare for a public issue due to administrative difficulties. The random selection requires transparency of the process such as publication of the actual serial numbers and how they were selected.

A refunding provision is the right of the issuer to replace an outstanding issue with another lower coupon. This is different from a call provision because the intention of refunding is to replace the outstanding bond with a similarly structured but lower coupon thus saving the issuer some interest expense. The investors are given the same number of bonds, unlike in a call provision when investors receive cash.

Watch for non-refundable and non-callable provisions. Non-callable means there is absolute protection that an issuer is not permitted to redeem the bond prior to maturity. Non refundable means that the issuer can only call the bond as long as it is not for refunding purposes, for example to reduce their debt level.

A prepayment option is similar to a call option in that the issuer may retire a portion of the principal borrowed. However, unlike a call option, there is no pre-specified price associated with the retirement of the debt principal. The term is commonly used and associated with mortgage-backed securities but not generally practiced with corporate bonds. With mortgage-backed securities, the behaviour of the individual mortgage borrowers are independent of the legal contract between the issuer and the investor of the securities.
A sinking fund provision can also be seen as an early retirement option rather than a provision for paying off the bonds. A stipulation in the indenture may require that the issuer retire a specified portion of the bond each year. For example, a 10-year $100 million bond can be retired at $5 million per year so at maturity the outstanding bond is only half of the original principal. Often there is an additional option for the issuer to retire more than the amount specified in the sinking fund provision. This is called accelerated sinking fund provision.
Index amortizing notes are bonds with an accelerated principal repayment provision based on a pre-determined reference rate. Like a floating-rate coupon structure, the provision is triggered when the reference rate is met or exceeded but unlike the floating-rate structure the provision applies to the principal not the coupon.

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