Flat Bonds: Definition, Calculation, and Practical Applications
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Summary:
Flat bond pricing is a fundamental concept in the bond market, referring to the price of a bond without accrued interest. This article delves into the nuances of flat bonds, including their calculation, when they are quoted, and their significance in different markets.
What is flat bond?
Flat bond refers to the price of a bond excluding any accrued interest. Accrued interest represents the portion of a bond’s coupon payment that the holder earns between scheduled coupon payments. The price of a flat bond is also known as its clean price.
Understanding flat bonds
How flat bonds are quoted
In the bond market, prices of interest-bearing instruments are quoted either at a full price or a flat price to account for interest payments. A flat bond price excludes any accrued interest, ensuring clarity for investors and preventing confusion regarding yield-to-maturity (YTM) calculations.
Calculation of flat bond price
The price of a flat bond is calculated by subtracting the accrued interest from the full (dirty) price. Accrued interest is determined by multiplying the coupon payment for the period by the time held after the last coupon payment or coupon period.
When to quote flat bonds
Reasons for trading flat
Flat bonds are typically quoted under the following circumstances:
- No interest is currently due on the bond, according to the date of sale and terms of the bond’s issue.
- The bond is in default, necessitating trading flat without calculation of accrued interest.
- The bond settlement date coincides with the interest payment date, resulting in no additional interest accrual.
Coupon period and calculation
The coupon period represents the number of days between each coupon payment date. Corporate and municipal bond issuers often assume a 30-day month and a 360-day calendar for accrued interest calculations. However, government bonds may use the actual/actual day count method.
Example: Flat bond calculation
Consider a scenario where a $1,000 par value bond pays interest semi-annually at a 5% coupon rate on February 1 and August 1 each year. If the bondholder sells the bond on April 15 for a full price of $995, the flat bond price can be calculated as follows:
- Coupon payment per period = 5% ÷ 2 * $1,000 = $25
- Stated coupon period = 6 months * 30 days = 180 days
- Number of days the bond was held after the last coupon payment before selling = 2.5 months * 30 days = 75 days
- Accrued interest = $25 * (75 ÷180) = $10.42
- Price of flat bond = $995 – $10.42 = $984.58
Frequently asked questions
Why are flat bonds quoted differently in American and European markets?
In American markets, flat bond prices are typically quoted to provide clarity on bond pricing without accrued interest. Conversely, full prices, including accrued interest, are more prevalent in European markets.
When should I use flat bond pricing?
Flat bond pricing is useful when no interest is presently due on the bond, if the bond is in default, or if the bond settles on the same date as the interest payment date.
Key takeaways
- A flat bond is one that does not account for accrued interest owed to the bondholder.
- Flat bond prices are typically quoted in American markets, while full prices are more common in European markets.
- Flat bond pricing is useful when no interest is presently due on the bond, if the bond is in default, or if the bond settles on the same date as the interest payment date.
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