Bonds are generally viewed as a more stable and predictable form of investing compared to the stock market since they help the holders ride out the volatility of the stock market, no matter which direction the market might be headed. But new investors, and sometimes, even seasoned investors, find challenging to understand bond pricing.
In this blog, we will understand what the clean and dirty price of a bond is and how it is relevant.
What Is a Bond Price
While it is relatively simple to understand what a bond is, bond’s Clean Price and Dirty Price can be confusing.
The coupon payment could be made monthly, quarterly, half yearly or annually. Half-yearly coupon payments are known to be the most common but there is no hard and fast rule.
Investors have the option to hold on to their bonds till maturity. But the concept of clean and dirty price comes in when a bondholder wants to sell it to another buyer before maturity.
Here’s an example.
If the coupon payment of a bond is done every 6 months, let us assume that Rajesh, being the current bondholder, receives the coupon payments every 31st march and 30th September.
Rajesh has found a buyer, Gopal. If Rajesh wants to sell his bond on the 1st of June, what bond price shall he ask Gopal to pay?
Between the time of receiving the previous interest and selling his bond, Rajesh is due to receive his accrued interest for 2 months. Hence, Rajesh will ask for a bond price which will include the interest accrued between 31st march and 1st June.
Understanding the Change in Bond Ownership
While the face value of the bond as of 1st June will definitely be considered, what happens to the interest accrued for 2 months – April and May?
The next interest receivable by the then bondholder, Gopal, will be on the 30th of September, but will it be fair and accurate for Gopal to receive the interest payment of the whole 6 month period if, in reality, he will have owned the bond only for 4 months – June to September?
The bond issuers do not get into these details of bifurcating the coupon payments between new and current bondholders.
- For such circumstances and transactions, we have a clean price and a dirty price.
- The bond price, which includes the interest accrued, is called the Dirty Price.
- The bond price, excluding the interest accrued, is called the Clean Price.
Let’s understand this numerically.
In India, Government securities typically pay interest twice a year
Let’s assume Rajesh has bought a 9.00 GS 2026 bond. It denotes that it is government security with a coupon rate of 9.00% and the maturity date is in 2026. The coupon payment is made semi-annually – on 30th September and 31st March.
If Gopal buys the bond from Rajesh on 1st June for a price of 1 Lakh rupees.
To calculate the dirty price, we first need to know the interest accrued since the last coupon payment.
As the last payment was made on 31st march and the bond was sold to Gopal on the 1st of June, the calculations will look like this:
Getting Familiar with Government Bonds
Government securities are one of the most common bonds in India. They are known as G-Sec.
While purchasing a bond, an investor can find all the details from date of maturity, yield on offer, face value, etc. on government websites like CCIL or RBI. An important point to note is that all the bonds on these websites show the clean price of a bond.
Hence, if you are not purchasing the bond on the date of coupon payment, you will likely have to pay the accrued interest to the investor who you are buying from.
So, while the websites show the clean price, you will probably have to pay the dirty price.
Clean And Dirty Price Affecting the Decision Making of Bond Purchases
Dirty price helps the bondholders to be assured that they will always get paid the interest accrued for a certain period, irrespective of the timing of their selling the bond.
This strongly works in favour of an investor during the decision-making of buying a bond.
On the other hand, during the time of selling the bond, the new buyer who buys from the previous bondholder is usually aware of the fact that he shall have to pay the interest accrued for a certain period.
That is another reason why ideally, all investors prefer buying a bond from a bondholder immediately after the coupon payment is made. This way, the investor can buy the bond at a clean price.
Conclusion
With bonds becoming a popular investment option for consumers, as well as institutions and a stable medium to raise capital for businesses, the above article will help you understand the basics of how this instrument works.
If you want to know more about bonds and how they work, check out Yubi Invest.
